Corporate Bond Market Suffers Bout of Indigestion
Corporate credit spreads widened, albeit from levels that are still near multiyear lows.
The corporate bond market suffered a bout of indigestion last week. Between absorbing a healthy amount of new issues and profit-taking from early year-end window-dressing, corporate credit spreads widened, albeit from levels that are still near multiyear lows. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 5 basis points to +104. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 24 basis points to end the week at +376.
A healthy amount of new issues came to market as issuers looked to take advantage of the small window between third-quarter earnings reports and the beginning of the holiday season next week. The new issues priced at the beginning of last week were sold without offering a new-issue concession to where the existing bonds were trading, but by the end of the week, new-issue concessions widened to 20 basis points in some cases to develop investor demand. For example, Apple (AA-, negative) started the week with its fifth issue of U.S. dollar-denominated senior notes this year. Before this offering, Apple had sold $23 billion of dollar-denominated notes and $9.5 billion of foreign-currency-denominated notes since January. In this most recent offering, Apple sold another $7 billion of notes with maturities ranging from 2 to 30 years. Immediately following the Apple offering, Oracle (AA-, stable) brought a $10 billion transaction to market. As the market was still digesting Apple's AA- rated technology offering, Oracle had to sell its offering at a discount to where its existing bonds were trading in the secondary market. Finally, among the multi-billion-dollar deals last week, United Parcel Service (A+, stable) sold a total of $6.6 billion of notes denominated in U.S. dollars and euros toward the end of the week. UPS also had to sell its offering at a wide concession to where its existing bonds were trading.
Further pressuring the corporate bond market, interest rates rose across the U.S. Treasury bond market yield curve. The yield on the 2-year Treasury bond rose another 4 basis points to 1.65%, continuing its march higher and hitting its highest level since October 2008. The yields on 5-, 10-, and 30-year Treasury bonds rose 6-7 basis points, ending the week at 2.05%, 2.40%, and 2.88%, respectively. The yield on the 2-year bond has been trending steadily higher for several years and has outpaced the increase of longer-term bonds. As such, the yield curve has been flattening and the spread between the 2-year and the 10-year has tightened.
Historically, a flattening yield curve has been a leading indicator of a potentially weakening economy. This time around, however, this signal may be distorted by global central bank actions. The short end of the curve is being directly influenced by the Federal Reserve, which is hiking short-term rates, whereas the long end of the curve may be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. Even though the 10-year U.S. Treasury is yielding only 2.40%, that is attractive to global bond investors as the yield on Germany's 10-year bond is only 0.41%, and the yield on Japan's 10-year bond is barely positive at 0.04%. From an economic perspective, growth in the short term appears to be healthy. GDP was reported to be a relatively strong 3.0% in the third quarter, and the GDPNow model forecast produced by the Federal Reserve Bank of Atlanta for real GDP growth in the fourth quarter is 3.3%.
This flattening trend may continue to be influenced by global central bank monetary policy. While the Federal Open Market Committee held off on raising short-term interest rates at its November meeting, the futures market for the federal funds rate has priced in an interest rate hike following the December meeting as fait accompli. According to the CME FedWatch Tool, the market is pricing in a 100% probability of a rate hike in December. The European Central Bank announced that it would not begin to taper its asset-purchase program until next year. Even then, the ECB will continue to continue to purchase EUR 30 billion per month until September 2018 and noted that purchases could be extended if warranted. While this places the ECB on the path toward a more normalized monetary policy late next year, these purchases will still infuse the eurozone with EUR 270 billion of new money that will need to find a home somewhere, and the ECB's main financing rate remains at 0%.
Energy Companies' Credit Quality Expected to Continue to Improve;
2018 Oil Forecast $55-$60
A confluence of global events recently drove the crude oil futures price curve into backwardation, a condition in which a commodity's market price today (or spot price) is higher than the price for further-out month contracts. As of this writing, the spot price for West Texas Intermediate crude is $56.90/barrel and the December 2018 contract is priced at $55.70/barrel. Typically, the oil market trades in contango, which is the opposite of backwardation. In contango, a commodity's spot price is below the price for further-out month contracts.
Backwardation primarily occurs when there is a shortage of a commodity in the spot market. Because it is infrequent and typically does not last long, the condition has often signaled a price top in the past. However, the exact timing for a price reversal is speculative at best. The factors aligning to create more bullish sentiment in the marketplace and cause the crude oil price to squib higher since mid-October include (1)) a focus on a modest draw-down of global crude inventories since the beginning of 2017, evidence that supply/demand fundamentals are gradually tightening, (2) a near-certain market view that OPEC will extend the production cut agreement when the cartel meets Nov. 30, (3) fears of more significant Venezuelan and Iraqi oil production outages caused by worsening political and economic crises, and (4) political uncertainty created by a sweeping purge of royals, officials, and businessmen in Saudi Arabia last week. Although we think the likelihood of a near-term price correction is building, we maintain a constructive long-term view, with no change to our price forecast for WTI oil of $55-$60/barrel in 2018. Our long-term view is underpinned by sharp cuts in global exploration and production expenditures during the past three years, which is helping to bring about a more balanced crude oil supply/demand balance. Commensurate with our price forecast and a strict industry focus on costs, we think the overall credit quality of companies in the energy sector will continue to improve next year. (Contributed by Andy O'Conor, assistant vice president, energy sector.)
High-Yield Fund Flows
For the fourth consecutive week, open-end high-yield mutual funds and high-yield exchange-traded funds registered an outflow. The net amount of outflows was $0.8 billion, consisting of redemptions of $0.3 billion in open-end funds and $0.5 billion in ETFs. Over the past month, total outflows are $1.8 billion, equally split between open-end high-yield mutual funds and high-yield ETFs. The amount of outflows over the past month represents one fourth of the total outflows the high-yield asset class has registered this year. Year to date, the high-yield asset class has suffered total redemptions of $7.4 billion, consisting of $11.3 billion of redemptions in open-end mutual funds offset by $3.9 billion of new unit creation in ETFs. Typically, ETFs are considered a proxy for institutional investor demand, which is often more correlated to changes in the corporate credit spread, whereas open-end funds are considered a proxy for individual investors and correlated to changes in the absolute yield.
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