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Credit Insights

Corporate Credit Spreads Nearing Multiyear Lows

Quantitative tightening to begin next month.

Corporate credit spreads continued to tighten last week and are rapidly approaching multiyear lows. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 3 basis points to +108 last week and the average credit spread of the BofA Merrill Lynch High Yield Master Index tightened 9 basis points to +364. Most recently, corporate credit spreads had bottomed out at +106 and +355, respectively, at the end of July. Over the past few years, the tightest that credit spreads registered was in mid-2014, when they reached +101 and +335, respectively. Credit spreads have only ever been tighter in the runup to the 2008-09 credit crisis.

In conjunction with credit spreads nearing their lows, volatility has also declined back toward its historical lows. At the end of the day Friday, the CBOE Volatility Index registered 9.6, one of the lowest readings since its inception. Market volatility and corporate credit spreads have been highly correlated over time. Based on the average spread of the Morningstar Corporate Bond Index since 1990, the VIX and investment-grade credit spreads have an R-squared of approximately 85%.

Interest rates on U.S. Treasury bonds rose as the demand for safe-haven investments dwindled and investors priced in a higher probability that the Federal Reserve will lift the federal funds rate one more time this year. Following the Fed's meeting last week, the market-implied probability that the Fed will raise the federal funds rate after the December meeting surged. According to CME Group, the probability of a rate hike in December rose to 78%, a substantial increase from the 53% probability priced into the market the prior week and the 39% probability registered one month ago.

Quantitative Tightening to Begin Next Month
As widely expected, the Federal Reserve maintained the targeted federal funds rate at 1%-1.25% and announced it will initiate its balance sheet normalization program in October. The balance sheet reduction 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 per month every three months until it reaches a total monthly run-off rate of $50 billion (an annual run rate of $600 billion). Considering that the total amount of assets currently held by the Federal Reserve banks is approximately $4.5 trillion, this is a very modest pace of reduction. Over the course of the next 12 months, if the Fed increases the reduction every quarter, the total amount of reduction would be $350 billion. From there, the total amount of reduction by October 2018 would be just shy of $1 trillion. Depending on the amount of assets it will want to retain on its balance sheet, the Fed will have let $2.75 trillion roll off by October 2022, which would leave approximately $1.75 trillion.

High-Yield Fund Flows
For the week ended Sept. 20, high-yield exchange-traded funds and open-end mutual funds experienced a net inflow of $0.7 billion. The $0.8 billion of inflows in the ETF sector were slightly offset by $0.1 billion of outflows across the open-end mutual funds.

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