High Yield Outperforming Investment Grade, and We Expect That Trend to Continue
Greek drama interesting to watch, but not meaningful to overall picture.
Thus far this year, rising interest rates have led to losses in the investment-grade corporate bond market. For example, through July 10, the Morningstar Corporate Bond Index has declined 0.75%. This decline has mainly been driven by an increase in long-term interest rates, although widening credit spreads have accounted for a portion of the loss. Since the beginning of the year, the yield on the 10-year Treasury bond has risen 25 basis points to 2.42% and the 30-year Treasury has risen 46 basis points to 3.21%.
Typically, increased risk (such as the falling Chinese stock market and ongoing Greek tragedy) normally brings about a flight to safety in the markets; however, investors in the United States are more focused on the increasing probability that the Federal Reserve will begin to raise the federal funds rate later this year. Federal Reserve Chair Janet Yellen reinforced this notion last week during a presentation in which she said she continues to expect the Fed will begin to raise interest rates later this year, albeit at a gradual rate of increase. While she said her stance would be subject to changes in the economic growth rate and inflation expectations, as well as unanticipated developments that could delay or accelerate this first step, she expects that raising rates will be the first step to begin normalizing monetary policy.
Corporate credit spreads in the investment-grade sector have widened modestly since the end of last year. For example, the average spread of the Morningstar Corporate Bond Index has widened 10 basis points to +150 basis points over Treasuries, only slighter tighter than the long-term average of +158. While credit spreads in the investment-grade sector have widened, spreads in the high-yield sector have tightened slightly year to date. The average spread of the Bank of America Merrill Lynch High Yield Index has tightened 7 basis points to +497. With its lower correlation to interest rates due to its lower duration and the benefit of higher carry from the wider spreads that high-yield bonds offer, the high-yield market has significantly outperformed investment grade thus far this year. The Bank of America Merrill Lynch High Yield Index has risen 2.38% year to date.
In our first-quarter outlook published late last year, we made our case on why we expected the high-yield market to outperform investment grade this year. Although much of the outperformance we expected in high yield for this year has already occurred, in our recently published third-quarter outlook, we opined that we expect high-yield bonds will provide a better return than investment grade over the second half of the year. The high-yield segment has a much lower correlation to underlying interest rates than investment-grade bonds and is more dependent on economic conditions. Even though the contraction in GDP for the first quarter was disappointing, Robert Johnson, Morningstar's director of economic analysis, projects full-year GDP growth of 2.0%-2.5%. This level of growth should be enough to hold down default rates, which will in turn support the high-yield market.
With the Fed indicating its desire to begin normalizing monetary policy later this year, we expect long-term interest rates will continue their march higher. The further increase in bond yields will then push bond prices down and offset much of the interest income that investment-grade bonds will generate over the second half of the year. In our view, based on a modest economic growth rate for the second half of the year, a more normalized range of the yield on the 10-year Treasury bond is 3.0%-3.5%.
Greek Drama Interesting to Watch, but Not Meaningful to Overall Picture
Earlier this month, Greek voters rejected the European Union's conditions to provide further bailout financing. However, Greece's prime minister has now agreed to a proposal similar to the EU's prior proposal. While there is a certain morbid fascination in watching the travails of Greece as it attempts to stave off a default, we do not think the new plan will significantly affect trading levels of credit spreads in the U.S. corporate bond market.
While the markets breathed a sigh of relief as Greece was able to strike an agreement and dodge a default and possible Grexit (leaving the eurozone), we don't necessarily see any reason for corporate credit spreads to tighten meaningfully. While credit spreads in the investment-grade market have widened year to date, the spread widening has been driven more by rising interest rates and economic contraction in the first quarter than by the concern that a Grexit would lead to systemic financial contagion. The high-yield market, which would be more adversely affected by the ramifications of systemic risk, has seen credit spreads more correlated to the movement in oil prices than to the heightened Grexit risk. Even if Greece had been unable to strike an agreement and defaulted on its debt, we did not foresee this as the catalyst to reignite concerns of systemic credit counterparty risk in the financial system.
It makes sense that the market is treating a Greek debt situation 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 on 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 European Central Bank. 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. As opposed to being a financial issue, a Greek default is more a political issue, as politicians will have to explain to their constituents why their countries 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.
Emerging-Market Bonds Holding Up, but May Be Susceptible
If Contagion From Sliding Chinese Equities Spreads
Over the past 52 weeks, the Shanghai index was on a tear, rising approximately 150% to its peak on June 12; however, since then, the index has fallen about 25%. Chinese officials have taken drastic measures to stem the slide. These measures include a ban on certain stockholders and government-owned corporations from selling shares and halting trading on approximately 1,300 companies. The halt has limited trading to 53% of the outstanding market.
Before the sharp downturn in the equity market, the Chinese economy had already experienced an economic slowdown as the rate of GDP growth has slowed over the past few quarters. To combat flagging economic growth, the Chinese central bank has lowered short-term interest rates several times this year and cut banks' reserve requirement ratios. Furthermore, the central bank has lowered the down payment required for a second home in an attempt to bolster dwindling property prices. During the second quarter, policymakers instituted a program to swap short-term loans to local governments for long-term bonds that can be pledged as collateral with the central bank for low-cost financing in order to free up liquidity and take pressure off refinancing near-term debt. This program will lengthen the maturities of local government loans, reduce interest rates on the debt owed by these local governments, and free up capital to make new loans.
Thus far this year, emerging-market bonds have performed well and have held up over the past few weeks. For example, the Morningstar Emerging Market Composite Bond Index has risen 2.52% year to date and is essentially unchanged since the end of last month. Within the composite index, the Morningstar Emerging Market Sovereign Bond Index has risen 1.52% year to date and the Morningstar Emerging Markets Corporate Bond Index has risen 3.28%. In the high-yield sector, the Morningstar Emerging Market High Yield Corporate Bond Index has risen 4.11%.
However, emerging markets are notorious for being an extremely volatile asset class in a "risk off' scenario. For example, in 2013, the Morningstar Emerging Market Composite Bond Index fell 4.43% as investors looked to repatriate cash during the taper tantrum (when interest rates rose sharply as the market priced in the end of the Fed's asset-purchase program). Investors in emerging-market bonds should keep an eye on the Shanghai index. If the index resumes its rapid decline, the risk-off sentiment could sweep across emerging-market bond funds.