Corporate Bond Market Wakes From Summer Slumber
Monetary policy expected to begin tightening at measured pace.
Following Labor Day, the corporate bond market woke from its typical summer slumber, when investors head to the beach instead of commuting to the trading desk. The new issue market sprang back to life as a multitude of issuers priced new transactions, which were generally well received in the marketplace, and trading volume in the secondary markets picked up. However, between the deluge of new supply, the potential economic impact of hurricanes Harvey and Irma, and expectations for impending changes in monetary policy, investors were unwilling to bid up prices for risk assets, preferring the safety of Treasury bonds.
The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened slightly last week to +115, and the average credit spread of the BofA Merrill Lynch High Yield Master Index widened 10 basis points to +392. Although corporate credit spreads have widened modestly from their recent lows at the end of July, they remain much tighter year to date. Since the end of last year, investment-grade corporate bond spreads have tightened 13 basis points and high-yield spreads have tightened 29 basis points.
As risk assets weakened to some extent, investors continued to bid up the prices of Treasury bonds, sending yields down to the lowest levels since before the presidential election. The yield curve tightened anywhere from 8 to 11 basis points, with the long end of the curve performing the best. At the end of business Friday, yields on the 2-year, 5-year, 10-year, and 30-year were 1.26%, 1.64%, 2.06%, and 2.67%, respectively. Year to date, the yield curve has flattened meaningfully as the yield on the 2-year has risen 7 basis points, whereas the long end of the curve has tightened between 32 and 38 basis points. In Europe, interest rates have declined to their lowest levels since June. For example, the yield on Germany's 5-year bond is a negative 0.38% and the yield on the 10-year is 0.31%.
Between tighter credit spreads and lower interest rates, corporate bond indexes have posted very strong returns thus far this year. Through Sept. 9, the Morningstar Corporate Bond Index (our broadest measure of the fixed-income universe) has registered a 5.71% gain and the BofA Merrill Lynch High Yield Master Index has risen 6.27%. The Morningstar Core Bond Index (our proxy for the overall fixed-income universe) has risen 4.04%, with the preponderance of the gain being driven by the long end of the yield curve. The Morningstar Long Term Core Bond Index has risen 7.95% this year, whereas the Morningstar Short Term Core Bond Index has increased only 1.74%.
Monetary Policy Expected to Begin Tightening at Measured Pace
The next Federal Open Market Committee meeting of the Federal Reserve is scheduled for Sept. 19-20. The market expects the Fed to announce that it will begin its balance sheet reduction program in October. The program will scale back the Fed's current reinvestments to allow $10 billion of assets to roll off per month and then increase the pace of reduction by $10 billion until it reaches a total monthly runoff rate of $50 billion (an annual run rate of $600 billion). To put the run rate in context, the total amount of assets currently held by the Federal Reserve banks is $4.45 trillion.
While market expects that the Fed will begin to reduce the size of its balance sheet, the market-implied probability that the Fed will hike the federal funds interest rate one more time this year has been declining. Between the potential economic impact of the hurricanes, the debt ceiling crisis that will come to a head in December, and continued global tensions, the probability of a rate hike has fallen to 28% from as high as 42% at the beginning of September.
In Europe, the European Central Bank has implied that it will announce at its October meeting its plan to begin winding down its asset-purchase program in 2018. However, the ECB will continue its quantitative easing program of purchasing EUR 60 billion of bonds per month through the end of this year (approximately another quarter trillion).
High-Yield Fund Flows
Through the week ended Sept. 6, net inflows into the high-yield asset class rose by $1.4 billion as compared with the outflows over the prior three weeks. Among the open-end funds, net inflows were $0.9 billion. Across the high-yield exchange-traded funds, there was $0.5 billion of net units created.
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.