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Credit Insights

Volatility Ramps Up and Spreads Reverse Course

Fed on hold; lowers longer-term rate hike forecast.

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Last week, volatility picked up and spreads widened ahead of Britain’s June 23 vote on whether to exit the European Union. The VIX jumped from 14 on June 9 and to above 22 on June 14, the day before the Federal Open Market Committee meeting. Those levels hadn’t been seen since mid-February amid the commodity sell-off and bottoming of crude oil prices. The volatility indicator closed the week at 19.4. Credit spreads are typically correlated with the VIX, as greater fear or uncertainty equates to higher risk premiums. Indeed, spreads have moved wider. The Morningstar Corporate Bond Index was at +147 basis points June 8 after mild tightening in the week or so prior and subsequently widened to +154 bps on June 17, a 5% increase. High-yield spreads, as measured by the Bank of America Merrill Lynch High Yield Index, similarly bottomed on June 8 at +586 bps but then widened to +621 bps on June 17. Treasuries, however, continued their one-way move down over the past month. The 10-year traded as low as 1.52% intraweek, but ended up closing at 1.62%, 2 basis points tighter on the week. Yields are 26 basis points lower since May 18.

In line with the backup in corporate credit spreads, high-yield fund flows turned negative on the week. After inflows of $0.5 billion and $0.8 billion the previous two weeks, an outflow of $2 billion was recorded last week. Since the end of April, about $3.5 billion of funds have come out of the high-yield market, but high-yield credit spreads are roughly at the same levels. The index reflected a loss of 0.7% on the week, tempering its strong performance year to date. Total returns are now 8.3% on the year. The energy sector, which still represents roughly 15% of the index, declined 1.4% as crude dipped back below $50. For the year, however, energy is up 20.4%, reflecting the sharp recovery after crude prices bottomed in February.

Fed on Hold; Lowers Longer-Term Rate Hike Forecast
As expected, the Fed did not raise interest rates at its June meeting, citing the slowdown in hiring in May along with potential risks associated with the Brexit vote this week. The tone at the post-meeting news conference shifted to more dovish as the projected trajectory upward in rates by FOMC participants through 2018 flattened. For example, the median projection for the federal funds rate is 25-50 basis points lower for 2017 and 2018 than it was after the March meeting, at 1.50% and 2.50%, respectively. While Fed Chair Janet Yellen did not eliminate the possibility of a July hike, the market pretty much pulled that off the table, pricing in a 7% probability versus 20% ahead of the meeting. The probability of one more hike this year fell to 43%. Meanwhile, global government bond yields stabilized. The 10-year German bund, which traded as low as negative 0.03%, ended the week at 0.00%. The U.K. 10-year settled down in the 1.12% area while the 10-year Japan bond stabilized at negative 0.15%.

New Issue Market Quiet, While Downward Trend in Ratings Continues
The new issue market continued to quiet down after a record May. Total investment-grade and high-yield issuers covered by Morningstar issued only $1.3 billion on two bond offerings last week, down from $11 billion and $35 billion the previous two weeks. Issuers tend to avoid periods of volatility, and the Fed meeting last week and the Brexit vote this week are likely to keep issuance muted. After that, we have a few more weeks before earnings season, with the July 4 holiday wedged in between, so issuance might pick up on a spot basis.

Morningstar had a mix of rating actions last week. In the telecommunications, media, and technology sector we followed a string of recent downgrades by putting stalwart Microsoft (MSFT) (rating; AAA/UR-, wide moat) under review with negative implications on its proposal to acquire LinkedIn for $26 billion. Should we downgrade Microsoft, that would leave only Johnson & Johnson (JNJ) (rating: AAA, wide moat) and ExxonMobil (XOM) (rating: AAA, narrow moat) as triple A rated issuers at Morningstar. We downgraded AbbVie (ABBV) (rating: BBB+, narrow moat), initiated credit coverage of Shire (SHPG) (rating: BBB-, narrow moat) (which was also effectively a downgrade of acquiree Baxalta, formerly rated BBB+), and raised our rating on MGM Resorts International (MGM) (rating: BB-, no moat). For the year, downgrades now exceed upgrades 35 to 12.

Rick Tauber does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.