Credit Spreads on Investment-Grade Corporate Bonds Tighten to Multiyear Lows
Asset volatility closing in on new low.
It was a quiet summer week in the corporate bond market last week. Volatility remained especially muted, the news flow was unusually uneventful, and there were no new issues of any significance. The stock markets marched higher, and the S&P 500 hit a new high. As expected in such an environment, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) continued its tightening trend, declining 2 basis points to end the week at +109, its lowest level since September 2014. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 10 basis points to +373. Year to date, the investment-grade bond index has tightened 19 basis points, while the high-yield index has tightened 44 basis points.
The last time investment-grade credit spreads reached this level was in mid-2014, when our index briefly traded as low as +101. The Morningstar Corporate Bond Index traded even lower during the runup to the 2008-09 credit crisis; however, part of the differential in credit spreads at that time compared with now is due to the fact that the average credit quality of the Morningstar Corporate Bond Index was single A for much of the time, whereas the current average credit quality is currently one notch lower at A-. As an indication of how tight corporate credit spreads have become compared with their historical averages, since the beginning of 2000, the average spread of the Morningstar Corporate Bond Index has registered below the current level only about 20% of the time.
Asset Volatility Closing In on New Low
Volatility in the asset markets continues to decline and is nearing its historical low. In the equity market, the CBOE Volatility Index (VIX) declined to 9.5 at the end of last week. Since 1990, there have been only two instances in which the index has registered the same or lower: Dec. 22 and Dec. 23, 1993, when the index registered 9.3 and 9.5, respectively. Factors that have helped suppress volatility include the lack of surprises in the first-quarter earnings season, weak economic growth, a decline in debt-funded M&A, and diminishing geopolitical risk. Market volatility and corporate credit spreads are highly correlated as the spreads of the Morningstar Corporate Bond Index and the VIX have an r-squared of about 85%.
Although volatility is at new historical lows, with second-quarter earnings reports due to begin in earnest this week, some investors are reducing their exposure to the high-yield asset class. Last week, investors pulled a net $1.4 billion out of the high-yield market. The net withdrawals were driven by redemptions from open-end mutual funds as high-yield exchange-traded funds experienced a small inflow of $0.2 billion.