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Credit Insights

Sliding Commodity Prices Send Credit Spreads Wider

We expect the high-yield sector to continue to outperform the investment-grade sector in the second half of the year.

Commodity prices have slumped over the past few months and picked up speed to the downside this month. Softening global economic growth, especially in China, has reduced demand for industrial raw materials. From iron ore to coal, prices for basic material commodities have fallen precipitously. In fact, the price of copper (which has one of the highest historical correlations to economic growth) has fallen to its lowest level since mid-2009. As these commodity prices have fallen, the average credit spread in the basic materials sector of the Morningstar Corporate Bond Index has risen 32 basis points since the end of last year to +220 basis points over Treasuries. Of this widening, 25 basis points has occurred just since the beginning of the month. This is widest level this sector has registered since mid-2013. The basic materials sector constitutes 5.5% of our index and is responsible for much of the widening of the overall investment-grade market.

As global economic growth has slumped, falling oil prices have also taken their toll on the credit markets. After stabilizing around $60 per barrel earlier this summer, oil prices resumed their decline, falling to $48 per barrel as of last Friday. The energy sector constitutes more than 10% of the Morningstar Corporate Bond Index and has widened 12 basis points since the beginning of the month to +203 basis points over Treasuries. This is the widest level the sector has traded since April, when oil prices were last below $50 per barrel.

Given the pressure from the basic materials and energy sectors, credit spreads in the investment-grade sector continued to leak wider last week. The average spread of the Morningstar Corporate Bond Index widened 2 basis points to end the week at +156. Year to date, credit spreads have widened 16 basis points and are at their widest level of the past two years.

The impact of weakening commodity prices has had an outsize impact in the high-yield market. As jump-to-default risk rises in these two sectors, credit spreads have widened drastically. In the Bank of America Merrill Lynch High Yield Index, the average spread of the metals and mining sector has widened 190 basis points to +1,169 since the end of last month, and the energy sector has widened 180 basis points over the same time frame to +892. In the Bank of America Merrill Lynch High Yield Index, the basic industry sectors account for 12% of the index and the energy sector accounts for 14% of the index. As such, the overall high-yield index has widened 32 basis points since the beginning of the month to +532 basis points.

Although the demand for high-yield bonds picked up the prior week after the Greek government acquiesced to the European Union's conditions to provide further bailout funding, it died down quickly last week. Through last Wednesday, the asset flow of high-yield mutual funds and exchange-traded funds fell by $0.1 billion, and we suspect even more funds flowed out of the asset class on Thursday and Friday as equity markets slid.

Even though global growth may be experiencing a slowdown, Robert Johnson, Morningstar's director of economic analysis, projects full-year GDP growth in the United States to range between 2.0% and 2.5%. While the depressed prices of commodities will impair the credit quality of the companies in those sectors, this level of economic growth should be enough to hold down default rates, which will in turn support the high-yield market. In addition, the Federal Reserve still appears to be on course to begin raising short-term interest rates later this year, which may have the knock-on effect of pushing long-term rates higher. With the expectation that default rates will remain low and interest rates appear poised to head higher, the high-yield sector, with its lower duration and higher credit spread, should continue to outperform the investment-grade sector in the second half of the year.