Investment-Grade Corporate Bond Rally Runs Out of Steam
Federal Reserve holds steady; timing of future rate hikes ambiguous.
After 10 weeks, the rally in the investment-grade corporate bond market finally ran out of steam last week. The average spread of the Morningstar Corporate Bond Index closed last week at +146, unchanged from the prior week. High yield eked out a small gain as the average spread of the Bank of America Merrill Lynch High Yield Index tightened 5 basis points to +624. Treasury bonds performed well as global investors sought safety from currency fluctuations. Highlighting the sensitivity to central bank machinations, the yen soared higher after the Bank of Japan announced it would not increase the monetary stimulus that it is already providing to the Japanese economy. Immediately after the BOJ's news, the yen rose more than 3% versus the U.S. dollar and by the end of the week had increased 4.6%. At an exchange rate of JPY 106.45 to $1, the yen is at its strongest level against the dollar since October 2014. In addition, after the Federal Reserve released its statement following the April Federal Open Market Committee meeting, the value of the euro rose more than 1.3% versus the dollar. At an exchange rate of EUR 1 to $1.1454, the value of the euro is near its highest levels since the beginning of 2015.
Federal Reserve Holds Steady; Timing of Future Rate Hikes Ambiguous
The Federal Reserve released its statement following the April meeting of the Federal Open Market Committee. The Fed made a few changes in its language, but the statement continued to be purposely ambiguous as to what and when the next moves might be. The market will need to wait until May 27, when Federal Reserve Chair Janet Yellen is next scheduled to make a public speech, to parse her words for a hint at the Fed's current view. Before its next meeting June 14-15, the Fed will be able to analyze two more months of economic data. While job growth has been encouraging, inflation remains below the Fed's target level and economic activity has been slowing. The sequential annualized growth rate of U.S. GDP has declined for the past three quarters. U.S. economic growth has declined from 3.9% in the second quarter of 2015 to 2.0% in the third quarter of 2015, 1.4% in the fourth quarter of 2015, and 0.5% in the first quarter of 2016. For details on the breakdown of first-quarter GDP and the economic outlook for the remainder of the year, please see Morningstar director of economic analysis Robert Johnson's most recent article, "U.S. Economy: A One-Trick Pony." In addition to the slowdown in economic activity, inflation appears to be slipping. On Friday, the Bureau of Economic Analysis released the March report for personal consumption expenditures (the Fed's preferred measure of inflation). The year-over-year increase in headline PCE decelerated to 0.8% from 1.0% last month, and the year-over-year increase in core PCE slipped to 1.6% from 1.7%.
In addition to digesting the regular economic data and outlook, the Fed's action at the June meeting may be complicated by international factors. On June 23, Britain will vote on whether it will remain part of the European Union. If Britain decides to exit the EU, many believe this could lead to significant economic disruption within the EU.
If the Fed does not raise rates at the June meeting, there appears to be a significant chance that it might not act until December. The next meeting will be held in July, but that one does not have a scheduled press conference or updated economic projections. Considering the significance of raising rates, most believe it's highly unlikely that the Fed would raise rates without releasing updated economic projections and holding a press conference to relay its reasoning. The following meeting Sept. 20-21 does have a press conference and economic projections scheduled, but it will be less than two months before the presidential election. The Fed may not wish to raise rates so close to an election, as it would not want its moves to be interpreted as politically influenced. There is another meeting Nov. 1-2, but it is even more unlikely that the FOMC would raise rates the week before an election. That leaves the Dec. 13-14 meeting, which does have a press conference and updated economic projections scheduled.
First-Quarter Earnings Reports Lackluster; Technology Remains Weak
Last week, we noted that first-quarter earnings reports had been a mixed bag, with results generally weak but not as bad as many feared. Among the general trends we identified, results from companies whose revenue relies upon sales to other companies or is weighted toward international consumers (such as the technology sector) were generally weaker than expected, whereas companies reliant upon the U.S. consumer have held up relatively well.
Following weaker-than-expected results from Alphabet (GOOGL) (rating: AA, wide moat) and Microsoft (MSFT) (rating: AAA, wide moat) the prior week, Apple (AAPL) (rating: AA-, narrow moat) reported its first year-over-year quarterly revenue decline since 2003 and the first-ever decline in iPhone sales. On the basis of the poor performance, reduced guidance, and the plan to issue more debt to fund share buybacks, Morningstar corporate credit analyst Michael Dimler lowered his recommendation to underweight from market weight.
Among the companies that have benefited from ongoing consumer resilience, Royal Caribbean Cruises (RCL) (rating: BB+, narrow moat) reported strong EBITDA growth based on strong demand in the Caribbean combined with better-than-expected onboard spending. We maintain our positive outlook on Royal's credit rating based on the expectation that profit margin improvements will be sustainable and the company will probably reach its goal of reducing net debt/EBITDA to below 3.75 times in early 2017, despite modest share repurchases. Management reiterated a financial policy that will adhere to a balanced approach toward growth capital spending, a return of capital to shareholders, and achieving an investment-grade credit rating. We continue to recommend Royal's 5.25% bonds due in 2022 as a Best Idea, having recently traded at +238 basis points over the nearest Treasury. We anticipate that Royal's bonds could tighten an additional 30 basis points as its credit profile improves, potentially to investment grade.
Following Starbucks' (SBUX) (rating: A, wide moat) strong earnings report the prior week, we upgraded our credit rating to A from A- and initiated a stable outlook last week. This rating action reflects exceptional operational and financial performance and our expectation that the firm will generate similar performance over the near to intermediate term. Because of the ramifications of Yum Brands' (YUM) (rating: BB, wide moat) plan intended to enhance shareholder value, we downgraded our rating to BB from BBB and initiated a stable outlook. This rating action reflects Yum's intent to return $6.2 billion to its shareholders, separate Yum China in a tax-efficient debt-free transaction, and maintain ongoing return of capital through share repurchases and/or special dividends. The cash outflows are expected to be substantially debt-financed, and we estimate lease-adjusted leverage will be high and increase on a pro forma basis to about 6.0 times from 3.2 times.
High-Yield Fund Flows Lackluster as Well
After posting record-breaking inflows in February and March, high-yield fund flows have been lackluster over the past three weeks. Over the past three weeks, the cumulative amount of fund flows into high-yield open-end mutual funds and exchange-traded funds has been only $0.3 billion.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.