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Credit Insights

Corporate Bond Buyers Are in Control and in No Hurry to Buy

Fed remains on hold; waiting for stronger economic signals.

Trading action in the corporate bond markets continued to be soft last week. For most of the week, trading was very illiquid with glimpses of hope that trading action was improving, only for the resurgence in trading activity to be fleeting. There was still some activity in single A and BBB 5-year and high-quality 30-year paper, but both the short-term and 10-year parts of the curve struggled to find buyers. While it's not quite a buyers' strike, traders reported that buyers were in control and felt no urgency to put cash to work. Over the course of the week, spreads were weaker more often than not, and the average spread of the Morningstar Corporate Bond Index widened 4 basis points to end the week at +147. In the high-yield space, the average spread of the Bank of America Merrill Lynch High Yield Index widened 10 basis points to +473.

In conjunction with widening credit spreads, high-yield mutual funds and exchange-traded funds suffered their second consecutive weekly outflow, bringing the total amount of outflows of the past two weeks to $5.4 billion.

News surrounding the ongoing negotiations to refinance Greek debt continued to make the headlines, but daily trading activity appears relatively immune to the ever-changing story. Most recently, the run on Greek banks has forced the European Central Bank to increase the amount of emergency liquidity assistance to cover deposit flight. Between the deposit flight and increasing reluctance for the ECB to fund additional ELA, Greece may need to implement capital controls to contain the situation. However, even if the situation continues to deteriorate, we think it makes sense that the market is treating a Greek default and/or Grexit (Greece's exit from the eurozone) as a non-event. In our view, the current situation is nothing like it was in 2010, when a Greek default had the potential to initiate systemic risk and counterparty failures in the financial system. At that time, Greek debt was widely held throughout the European banking system, but yet no one knew exactly who held how much. Banks were concerned that even if they did not hold Greek debt themselves, a Greek default could weaken the solvency of other banks to which they had counterparty risk. After Greece restructured most of its debt and drew upon loans from official creditors, almost 80% of its debt is now held by organizations such as the International Monetary Fund, European Financial Stability Facility, and ECB. As such, the credit counterparty risk is no longer borne by the banking system and would not instigate the same systemic concerns that rippled through the financial markets as before. A Greek default is more a political issue than a financial issue, as politicians will have to explain to their constituents why they will most likely experience losses on their exposure, which will need to be absorbed by taxpayers. Depending on the size of losses experienced, this could have implications during the next round of elections across the eurozone.

Fed Remains on Hold; Waiting for Stronger Economic Signals
No one was surprised by the Federal Open Market Committee's decision to hold interest rates at zero, and the updated language in the FOMC statement was equally unsurprising. The Fed will continue to keep rates near zero as it awaits stronger economic data that indicates the economy is on solid economic footing. The interesting content was embedded in the Fed's updated economic projections and the change in the midpoint of the target level for the federal funds rate at year-end. For 2015, the Fed reduced its estimate of central tendency for 2015 GDP to 1.8%-2.0% from 2.3%-2.7%. It increased its estimate for the unemployment rate to 5.2%-5.3% from 5.0%-5.2%. Its estimates for personal consumption expenditures and core PCE were unchanged at 0.6%-0.8% and 1.3%-1.4%, respectively.

Each of the participants of the FOMC also estimates the appropriate level of the federal funds rate for several different periods. In the March 2015 projection table, the estimates for the December 2015 federal funds rate ranged from zero to 1.5% and averaged 0.6%; however, the projection table in this most recent forecast dropped to a range of zero to 0.75% and averages 0.4%.

Robert Johnson, Morningstar's director of economic analysis, continues to forecast real GDP growth of 2.0%-2.5% for calendar 2015. The contraction in the economy in the first quarter should prove to be an anomaly as the temporary factors (such as the port strike and abnormal winter weather patterns) wear off and economic activity returns to normal. In addition, the decline in oil prices from last year should provide a tailwind for consumer spending by the second half of the year to help spur further economic growth. Historically, there has been a three- to nine-month lag effect between the decline in oil prices and resultant increase in consumer spending. After incorporating the contraction in the first quarter, in order to reach Johnson's forecast, GDP will need to expand at more than an average 3% pace for the remainder of the year.

In such a benign environment, corporate credit spreads appear fairly valued. Currently, the average spread of the Morningstar Corporate Bond Index is about half a standard deviation tighter than its historical average. In our view, the greatest risk to bondholders in general will continue to be steadily rising interest rates and for corporate bondholders, idiosyncratic risk leading to credit rating downgrades. While we don't expect long-term interest rates will spike higher in the short term, we think that as monetary policy begins to tighten later this year, interest rates will rise as they normalize compared with inflation, inflation expectations, and the shape of the yield curve.

With their shorter duration, high-yield bonds are less correlated to movements in interest rates and returns are much more closely tied to economic growth. As such, we expect high-yield bonds will continue to outperform investment-grade bonds for the remainder of the year. Global events that would precipitate a general widening in credit spreads include a rapid decline in oil prices, a recessionary environment in the euro area, which could presage sovereign debt and banking concerns, or rapid deceleration of economic growth in China and the other emerging markets, which would pressure countries reliant on commodity exports.