Investment-Grade Credit Spreads Break Through 100 Basis Points
Risk assets continued their unrelenting trend higher last week.
Risk assets continued their unrelenting trend higher last week. Equity markets reached an all-time high, commodity prices generally trended upward, and compensation for underwriting corporate credit risk has tightened to its lowest level since the 2008-09 credit crisis. In the investment-grade market, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 2 basis points to +99. This is the first time the index has registered inside +100 since before the 2008-09 credit crisis. The tightest the index has ever reached was +80 in February 2007. In the high-yield market, credit spreads have not yet hit new post-credit-crisis lows but are within 13 basis points of reaching their recent lows in June 2014. The BofA Merrill Lynch High Yield Master Index tightened 18 basis points to end the week at +342. The tightest the index has registered over the past 20 years was +241 in June 2007.
As investors chased risk assets higher, they saw no need for safe-haven assets such as U.S. Treasuries. As demand waned, interest rates increased across the entire yield curve. The falling prices led to higher yields as interest rates rose between 9 and 12 basis points, with the belly of the curve between 5-year and 10-year bonds rising the most. With the market pricing in another interest rate hike to the federal funds rate as fait accompli this year, the interest rate on the 2-year Treasury is at its highest level since the Federal Reserve was in the midst of slashing interest rates during the credit crisis. Currently, according to CME Group, the probability of a rate hike in December is 93%. In mid-September, the market priced in a 58% probability, and at the beginning of September, it priced in a 32% probability.
Until there is a significant enough catalyst to the economic paradigm to reverse the current trends, risks to the corporate bond market appear low over the short term. Across the macroeconomic environment, while hurricanes Harvey and Irma caused significant damage where the storms hit land, they do not appear to have significantly impaired the larger U.S. economy. For example, the GDPNow forecast developed by the Federal Reserve Bank of Atlanta projects a 2.7% increase in third-quarter economic growth. In the microeconomic environment, idiosyncratic risk has been low as the number and size of management actions such as debt-funded acquisitions or accelerated stock-repurchase programs that damage balance sheets have been kept at a minimum. Additionally, while it is early in the earnings season, reports have generally been either in line or slightly better than expected, and management teams have been confident in their outlooks for the fourth quarter.
Although much has been written about the Catalonian separatist movement in Spain, there has not been any meaningful impact in the fixed-income markets. The yield on Spain's 10-year sovereign bond ended the week at 1.66%, only 121 basis points higher than Germany's 10-year bond (the sovereign benchmark in Europe). In the European corporate bond market, the average credit spread of the Morningstar Eurobond Corporate Index tightened 2 basis points last week to +86, which is only a few basis points higher than the tightest level it reached this past summer. Volatility remained low across the globe. In the United States, the VIX Index closed at 9.6 at the end of the week, only slightly higher than its historically lowest levels.
High-Yield Fund Flows
For the week ended Oct. 18, high-yield exchange-traded funds and open-end mutual funds experienced a net outflow of $0.6 billion. The outflows comprised $0.4 billion of withdrawals in the open-end mutual fund space and a $0.2 billion decline across high-yield ETFs.
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.