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Credit Insights

Investment-Grade Credit Spreads Grind Tighter, High-Yield Pauses

We also look at third-quarter reports for industrials.

Corporate credit spreads in the investment-grade market continued to push to new postcrisis lows last week, while credit spreads in the high-yield market paused as investors reassess this risky asset class. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 2 basis points to +97 last Thursday before backing off slightly to end the week at +98. Thursday's close marked the tightest the index has traded since before the 2008-09 credit crisis. For reference, the tightest the index has ever reached was +80 in February 2007. The BofA Merrill Lynch High Yield Master Index widened 2 basis points to end the week at +344. The tightest the index has registered since the credit crisis was +335 in June 2014, and the tightest the index has traded over the past 20 years was +241 in June 2007.

Investors have become increasingly comfortable paying higher prices and tighter credit spreads for risk assets as economies across the world are growing at solid rates. For example, despite the negative impact from two hurricanes that impaired large areas of the Southeast, gross domestic product in the United States was reported to have expanded at a 3% annualized rate in the third quarter. This follows a 3.1% annualized growth rate reported for the second quarter. With economic growth on solid footing in the U.S., the futures market for the federal funds rate has priced in an interest rate hike following the December Federal Open Market Committee meeting as fait accompli. Based on CME Group's FedWatch Tool, the market is pricing in a 100% probability of a rate hike in December. With the expectation that short-term rates will be nudged higher, the yields on U.S. Treasury bonds continued their recent trend upward last week as interest rates increased slightly across the yield curve. The long end of the curve rose the most, as 10-year Treasury bonds rose 3 basis points to 2.41% and 30-year Treasury bonds rose 2 basis points to 2.92%.

The European Central bank announced that it would begin to taper its asset-purchase program next year. Currently, the ECB is purchasing EUR 60 billion of fixed-income assets per month. This rate of purchases will continue through the end of this year, but will be pared to EUR 30 billion per month in January and run through September 2018. The ECB said the purchases could be extended further if warranted. While this places the ECB on the path toward a more normalized monetary policy, these purchases will still infuse the eurozone with EUR 270 billion of new money, and the ECB's main financing rate remains at zero. Both of these policies remain highly accommodative.

3Q Earnings Takeaways: Industrial Sector
Contributed by Basili Alukos, CFA, CPA
A bevy of industrial firms including bellwethers United Technologies Corp (A/UR-), Caterpillar Inc (A-, negative), and 3M Co (AA-, negative) reported earnings this past week that provided another glimpse into the financial well-being of the manufacturing hinterland. Overall, we'd classify the results as encouraging. As in quarters past, industrial firms reported solid low- to mid-single-digit quarterly organic growth rates. The continued resurgence in the energy patch fueled top-line growth in the housing, consumer, and aerospace end markets.

The stellar performer this week was Caterpillar. Revenue growth of 26.6%, coupled with a near-doubling of EBITDA, drove solid free cash flow generation. Management said the moribund mining cycle has started to turn, truck utilization rates are moving higher, and there is healthy demand for aftermarket parts. The better-than-expected performance enabled management to once again raise its 2017 outlook. 3M also delivered solid third-quarter results, as a 6.6% increase in organic local-currency sales boosted third-quarter sales and earnings per share to record levels. Organic volume growth increased 280 basis points sequentially. The performance compelled management to also raise its 2017 outlook slightly.

Looking to the transportation sector, the three remaining Class I rails that we cover--Canadian National Railway Co (A, stable), Union Pacific Corp (A, stable), and Norfolk Southern Corp (BBB+, stable)--also reported earnings. Echoing their peers from the previous week, the stories were again positive. Carload volume was up for two firms, although the effects from the devastating hurricanes created some headwinds for Union Pacific. Still, profitability and free cash flow generation generally improved, as core pricing power and operating efficiencies mitigated the impact of overall rail inflation. Management teams provided a tempered albeit encouraging outlook for the remainder of the year and early hints for 2018. They expect strength in intermodal and chemical commodities to likely be offset by a weakening automotive environment. So long as the manufacturing economy continues to run in high gear, we expect the rails to keep chugging along.

High-Yield Fund Flows
For the week ended Oct. 25, net fund flows in the high-yield asset class were essentially unchanged as the amount of outflows from open-end high-yield mutual funds were almost completely offset by inflows into high-yield exchange-traded funds.

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