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Credit Insights

Corporate Credit Spreads Widen in Response to Rising Geopolitical Tensions

The flight to the safety of U.S. Treasury bonds pushed interest rates lower.

Corporate credit spreads widened from their recent lows as geopolitical tensions escalated last week. After bottoming out at +105 at the end of July, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 10 basis points to +115, with the preponderance of the widening occurring last week. Similarly, since hitting its recent lows at the end of July, the average credit spread of the BofA Merrill Lynch High Yield Master Index has widened 45 basis points to +400. The equity market experienced a rare pullback as the S&P 500 declined 1.43%.

As investors looked to derisk portfolio allocations, the flight to the safety of U.S. Treasury bonds pushed interest rates lower. Interest rates peaked in mid-July and have been declining over the past month, with a substantial amount of the decline occurring last week. For example, since July 7, the yield on the 10-year Treasury bond has declined 20 basis points to 2.19%, with almost half of that decline occurring just last week. This action was not limited to the United States, as the yield on Germany's 10-year bond has declined 22 basis points since mid-July to 0.38%. In Switzerland, after briefly emerging above zero, the interest rate on long-term Swiss bonds slid back into negative territory as the yield on the 10-year Swiss bond declined to a negative 0.16%.

Though market sentiment has turned sour, there remains a strong underlying demand for U.S. dollar-denominated corporate bonds. As evidence, even though issuers typically shy away from the new issue market during August, which historically is the slowest month of the year as a significant number of institutional investors schedule vacations, British American Tobacco (rating: BBB, stable) decided to issue $17.25 billion of bonds to fund its acquisition of Reynolds Tobacco. This transaction is the second-largest corporate bond deal issued this year, surpassed only by AT&T's (rating: BBB/UR-) $22.5 billion transaction, which itself was the third-largest corporate bond deal in history. In addition, McCormick (rating: A+/UR-) issued $2.5 billion of new bonds to finance its acquisition of Reckitt Benckiser's food division. Acquisition financing is likely to remain the dominant theme over the near term as there remain several large strategic buyouts that will be debt-funded. For example, Amazon.com (rating: A, stable) is reportedly holding investor calls in preparation for the financing it intends to complete in order to buy While Foods.

With volatility rising from its historical lows, investors mostly stuck to the sidelines as fund flows in the high-yield market came to a near standstill last week. The minor amount of redemptions occurring among the open-end funds was exactly offset by inflows into high-yield exchange-traded funds.

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