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Credit Insights

Headlines Abound, but Corporate Bond Market Stays Its Course

New issue market taking a short breather; investors return to high-yield sector.

Headlines abounded last week, but none were able to change the course of the corporate bond market. The investment-grade market has been in mostly a holding pattern in which corporate credit spreads have been essentially flat over the past month; in the high-yield market, the demand for yield has helped credit spreads grind slightly tighter. The average corporate credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 1 basis point last week to +122. Over the past four weeks, the trading range of the average credit spread in the investment-grade index has fluctuated by only 2 basis points. In the high-yield market, the Bank of America Merrill Lynch High Yield Master Index tightened slightly as credit spreads declined 6 basis points to end the week at +386. Over the past four weeks, there has been a little more volatility in the high-yield market as the index has traded in a 30-basis-point range, but much of that volatility occurred in mid-March when oil prices briefly dipped below $50 per barrel.

After rising Wednesday morning, stock prices dipped in the afternoon after the March Federal Open Market Committee meeting statement was released. Included in the meeting minutes was this: "Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures."

The market volatility was short-lived. While some investors were concerned that the Federal Reserve views the equity market as overvalued, many other investors saw this as an opportunity to buy the dip and ramped equity prices back up by the end of the week. As a result, the S&P 500 ended the week with only a 0.30% decline, and the CBOE volatility index (also known as the fear gauge) was barely affected, rising to 12.9 by the end of the week from 12.4 the prior week. Comparatively, the volatility index has averaged almost 16 over the past five years.

In economic news, the employment situation was much weaker than expected as the payroll report indicated that employment grew by 98,000 in March compared with the consensus Street estimate of 175,000. Given lower-than-expected job growth, declining construction and manufacturing metrics, and deteriorating light-vehicle sales, expectations for GDP growth in the first quarter continue to decline. As an indication of the weakness among economic metrics, the Federal Reserve Bank of Atlanta reduced its GDPNow forecast to 0.6% growth for the first quarter. Its forecast had been as high as high as 2.5% as recently as Feb. 27. In our March 28 "Second-Quarter 2017 Corporate Credit Market Insights," we noted that Robert Johnson, Morningstar, Inc.'s director of economic analysis, expected GDP growth in the first quarter would only be about 1.0%. His estimate is well below the average consensus expectations of Wall Street economists; however, while the first quarter appears dour, he expects economic growth will rebound toward a more normalized level in the second quarter. Johnson forecasts second-quarter GDP to increase to 2.1%, and for the full year he estimates GDP growth of 1.75%-2.0%. Johnson expects that at the end of this year, the yield on the 10-year U.S. Treasury will be 3.00%-3.50% and the run rate of inflation will be 2.00% on a fourth-quarter over fourth-quarter basis.

New Issue Market Taking a Short Breather;
Investors Return to High-Yield Sector

The volume and number of new corporate bond issues brought to the capital markets has slowed as many issuers are entering their quiet periods before their first-quarter earnings releases. Earnings season will kick into gear later this week as companies (including the large U.S. banks) begin to report first-quarter results. New issuance should resume after earnings season as companies look to refinance near-term maturing debt or take advantage of low yields and relatively tight corporate credit spreads.

With volatility subdued, investors were willing to take on the added risk inherent in the high-yield asset class in a search for yield in the ongoing low-interest-rate environment. Fund flows into the high-yield sector rose to $2.4 billion last week, the third-highest weekly inflow over the past year. While a greater amount of inflows was directed to exchange-traded funds (typically institutional investors) than open-end mutual funds (typically individual investors), it appears that both types of investors were comfortable taking on added default risk in the current environment. 

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