Risk assets continued to trend higher last week as the S&P 500 hit an all-time high, corporate credit spreads tightened to multiyear lows, and volatility reached a new low. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) continued its tightening trend and declined 2 basis points to end the week at +107, its lowest level since September 2014. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 9 basis points to +364. Year to date, the investment-grade bond index has tightened 21 basis points and the high-yield index has tightened 57 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 was 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 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 19% of the time.
Asset Volatility at Historical Lows As an example of how much volatility in the asset markets has declined this year, in the equity market, the CBOE Volatility Index (VIX) fell to 9.36 at the end of last week. Typically, asset volatility would rise as the calendar shifts into earnings season, but reports have thus far been generally in line with expectations, and there have been few warnings that earnings will miss consensus expectations. Other factors that have helped suppress volatility are the ongoing bland economic environment, a decline in debt-funded M&A, and diminishing geopolitical risk. Market volatility and corporate credit spreads are highly correlated as the spread of the Morningstar Corporate Bond Index and the VIX have an R-squared of approximately 85%.
Interest Rates Subside Over short periods, the Treasury bond market performs best in a risk-off environment when other asset classes are selling off. However, even though assets have been on a steady upward trend and volatility is nearly nonexistent, the markets still bid up prices of Treasury bonds last week. For example, the yield on the 5-, 10-, and 30-year Treasury bonds declined 7, 9, and 11 basis points, respectively, to 1.80%, 2.24%, and 2.81%. Year to date, the yields have declined a total of 13, 20, and 18 basis points.
Bonds rallied on dovish comments from the European Central Bank, which held its monetary policy steady and said it had not begun to plan how and when it would begin to wind down its quantitative easing program. Currently, the ECB's main refinancing rate is 0%, the deposit rate is negative 0.40%, and the marginal lending rate is 0.25%. In addition, the ECB is purchasing EUR 60 billion per month of euro-denominated bonds; this is scheduled to run through the end of December and could be extended if deemed necessary. While the markets don't anticipate that the ECB will taper its quantitative easing program or raise its short-term interest rates anytime soon, an increasing number of news stories have postulated that ECB President Mario Draghi will use his speech at the Federal Reserve's annual economic conference in Jackson Hole, Wyoming, on Aug. 24-26 to lay out his thoughts on when the ECB will begin to normalize its monetary policy.
Although the Federal Reserve has begun normalizing monetary policy and has increased the federal funds rate several times, the interest rate futures market is not pricing in a substantial probability of another rate hike until December. Based on the current trading levels, the market-implied probability of the next rate hike occurring in December is 48%.
With volatility at historical lows and the stock market at historical highs, investors returned to the high-yield market as inflows into the high-yield asset class reached $2.0 billion last week. Inflows were driven by exchange-traded funds, which saw an inflow of $2.0 billion, while the assets of the open-end mutual funds were relatively unchanged.
Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization ("NRSRO"). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com.