Credit Insights: Volatility Remains Muted in Corporate Bond Market; Yield Curve Continues to Flatten
Volatility remains muted in corporate bond market; yield curve continues to flatten.
The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened one basis point to +116; whereas, the BankAmerica Merrill Lynch High Yield Master Index widened 3 basis points to +376. Volatility remained muted as credit spreads have traded in a very narrow range. Over the past four weeks, the average spread in the investment-grade market has only varied by 2 basis points, and in the high yield market, the average spread has only varied by 11 basis points.
The main impetus for the widening in the high yield market was the decline in oil prices to $44.70 per barrel, its lowest level since last November, which pushed the credit spread of the energy sector 20 basis points wider last week to +503. This is the first time that the spread of the energy sector has breached +500 since November 2016, when oil had last fallen below $45 per barrel. Year to date, the Morningstar Corporate Bond Index has tightened 12 basis points, and at its current level, the index is significantly tighter than its long-term average of 167 basis points. Since January 2000, the average spread of the index has only been tighter than current level 25% of the time. Similarly, the BankAmerica Merrill Lynch High Yield Master Index has tightened 45 basis points year to date and is 233 basis points tighter than its long-term average of 609 basis points. Since January 2000, the index has registered a lower spread only 15% of the time.
Following the Fed’s interest rate hike, Treasury bonds rallied with long-term bond prices outperforming short-term bonds, resulting in a flattening yield curve. While the yield on the 2-year Treasury bond only declined 1 basis point, the yield on the 30-year bond declined 8 basis points. While short-term interest rates remain near their highest levels since November 2008, long-term interest rates remain well below their March highs. While the yield curve has not quite yet flattened to the same levels as last fall, prior to last fall, the last time the yield curve was this flat was in November 2007.
- source: Federal Reserve Bank of St. Louis. Data as of 6/16/2017.
Currently, the market is pricing in low probability that the Fed will hike the federal funds rate again in the short term. The market implied probability that the Federal Reserve will raise the federal funds rate following the September FOMC meeting is only 16%. That probability increases to a 46% chance that the Fed will raise the rate at the December meeting.
Robert Johnson, Morningstar Research Service LLC’s Director of Economic Research thinks that the Fed is done for the year and will not hike rates again before 2018. According to his video, "No More Rate Hikes in 2017" uploaded on June 14, Johnson thinks it is more likely that the Fed will initiate its program to begin reducing the size of the Fed’s balance sheet as early as the September FOMC meeting. According to Johnson, the Fed’s plan will be to halt reinvesting the principal on maturing bonds to the tune of $10 billion a month. Yet, the Fed’s goal will be to increase the portfolio roll-off to $50 billion per month, which is an annualized rate of $600 billion. Considering the Fed’s balance sheet is well north of $4 trillion and would likely want to keep about $1 trillion of assets on its books, that would equate to a wind down that would occur over multiple years. Part of the reason that Johnson thinks that the Fed won’t hike rates again this year is that he is seeing growth slowing in a number of the sectors that have been the key drivers for the economy. While GDP growth in the second quarter will likely outpace economic growth in the first quarter, Johnson reiterated his forecast for real GDP growth for 2017 to range between 1.75% and 2%. The sectors that he specifically highlighted as weakening are aerospace, autos, equipment related to oil production, healthcare, and restaurant sales.
The new issue market was quiet as only a few issuers dared to tip their toe into the capital markets during a week in which the Federal Reserve was expected to hike interest rates. Among the companies we rate, Fifth Third Bancorp (FITB) (rating: BBB+, stable) sold $700 million fixed rate senior unsecured holding company notes. Our BBB+ credit rating for Fifth Third reflects the company's solid asset quality and loan-loss reserves, partially offset by a relatively higher-risk geographic footprint. Fifth Third is a diversified financial services company with $140 billion in assets as of December. The company operates around 1,200 branches mainly in Ohio, Michigan, and the greater Midwest. In our view, the company has done a good job of improving its credit quality by reducing its nonperforming assets to less than 1% of loans, less than half of its peak in 2009. Loan-loss coverage is solid, with reserves/nonperforming loans more than 186% at year-end. Both measures compare favorably with average levels for regional bank peers of 1% and 120%, respectively. Solid profits, including a 10.1% return on equity during 2016, were inflated by one-time gains from the sale of the company’s Vantiv payment processing business.
Fund flows into high yield open end mutual funds and ETFs declined for the third consecutive week, declining to $0.3 billion. Year to date, high yield fund flows remain decidedly negative as there has been a net redemption of $3.9 billion consisting of $4.7 billion withdrawal out of the open-end funds, which has only been partially offset by $0.8 billion of inflows into ETFs.
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David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.