Corporate Credit Spreads Trading Within Tightest Historical Decile
The average spread of the Morningstar Corporate Bond Index ended last week at its lowest level since before the global financial credit crisis.
Risk assets remained in vogue last week as investors bid up prices seemingly across the board on stocks and corporate bonds and sold off risk-free U.S. Treasuries and other sovereign bonds. Among economic indicators, fourth-quarter GDP increased 2.6%, missing consensus expectations, but the stock market continued to rise, hitting new highs, and credit spreads in the corporate bond market tightened. The main focus among corporate bonds was trading action in the secondary market. Following the flood of new issues from the banking sector two weeks ago, the new issue market dried up last week as few issuers looked to tap the capital markets.
The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 2 basis points and ended the week at +91, its lowest level since before the global financial credit crisis. Year to date, the average credit spread of the overall investment-grade index has tightened 5 basis points. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 12 basis points to end the week at +323, which is already 40 basis points tighter than at the end of 2017. This is the tightest level the high-yield index has registered since before the global financial credit crisis. The tightest that the investment-grade index has ever registered was +80, and the tightest the high-yield index has ever registered was +241, both in June 2007. Among other risk assets, the S&P 500 rose 2.23% last week and is already up 7.45% over the past 19 trading days thus far this year. After slipping the prior week, oil prices regained their momentum and rose $2.67 to end the week at $66.19 a barrel; they have risen $6.35 this year to their highest level since December 2014.
At current levels, the investment-grade and high-yield indexes are trading much tighter than their long-term historical averages. Since 2000, the average spread of our investment-grade index is +165 and the average spread of the high-yield index has averaged +599. As an indication of how tight corporate credit spreads have become compared with their historical averages, since the beginning of 2000, the average spread of the Morningstar Corporate Bond Index has registered below the current level only 7.8% of the time. In addition, the average credit quality of the Morningstar Corporate Bond Index is lower than it was much of the time. Currently, the average credit quality of the Morningstar Corporate Bond Index is A-, while since 2000, it has been single A for much of the time.
In the high-yield market, the average spread of the BofA Merrill Lynch High Yield Master Index has registered below its current level only 6.9% of the time over the past 18 years. Most of the time that the corporate bond market indexes were tighter than the current credit spread was during the buildup to the 2008-09 credit crisis.
Monetary Policy Continues to Affect Interest Rates
Between raising the federal-funds rate three times in 2017 and initiating its balance sheet normalization program last October, the Federal Reserve is well on its way to normalizing monetary policy. In anticipation of the increases in the fed-funds rate, the yield on the 2-year Treasury bond has been steadily rising over the past few years. However, the increase in interest rates across the longer-term portion of the yield curve has lagged the short-term as inflation and inflation expectations remain muted. As such, the spread between 2-year and 10-year Treasury yields has compressed significantly. At its current level, the yield curve is its flattest since October 2007.
In the past, when the yield curve has been flattening, it has often been an indicator of a weakening economy and in many cases portended an impending recession. This time around, this signal may not be foreshadowing a recession, as it is being heavily influenced by global central bank actions. Based on the Fed's statements and its own interest-rate forecasts, as well as the heightened probability for rate increases priced into the futures market, it appears that short-term rates may continue to head higher in 2018. Currently, according to CME Group's FedWatch Tool, the market is pricing in almost an 80% probability that the Fed raises the federal-funds rate at its March meeting. Over the rest of the year, the market is pricing in a 90% probability that the fed-funds rate at the end of 2018 will be greater than 1.75% and a 61% probability that the rate will be 2% or higher. The Federal Reserve released its updated projections following its December 2017 meeting, which includes forecasts by board members for the federal-funds rate. The average projected fed-funds rate from the board members for the next three years is 2%, 2.70%, and 3% for years ended 2018, 2019, and 2020.
Inflation expectations have risen thus far this year and are bumping up against the higher end of their 52-week range. Currently, the 5-year, 5-year forward inflation expectation rate (market-derived expectation for average inflation for five years, beginning five years from today) is 2.25%, some 20 basis points higher than where it ended 2017. Since October 2016, the 5-year, 5-year forward inflation expectation rate has traded within 25 basis points of 2%.
While the Fed's monetary policy actions have been directly affecting short-term rates, the long end of the curve may also be influenced by the ongoing quantitative easing programs of the European Central Bank and the Bank of Japan. The 10-year U.S. Treasury's 2.66% yield is attractive to global bond investors, as the yield on Germany's 10-year bond is only 0.63% and the yield on Japan's 10-year bond is barely positive at 0.08%.
This flattening trend may continue to be influenced by global central bank monetary policy. The futures markets fully expects the Fed will raise the federal-funds rate in March, and the European Central Bank will not begin to taper its asset-purchase program until September 2018. Until then, the ECB will purchase EUR 30 billion per month, which will infuse the eurozone with an additional EUR 240 billion of new money.
Highly Accommodative Financial Conditions Support Corporate Credit Risk
Corporate credit markets have been buoyed by a combination of generally improving credit metrics, fewer debt-funded mergers and acquisitions or shareholder-enhancement programs, and the market's expectation that revisions to tax and regulatory policies will bolster corporate credit strength by invigorating economic growth and boosting earnings. In addition to supportive fundamentals at the company level, the economic outlook remains constructive. The economy continues to expand at a healthy pace, rising 2.6% in the fourth quarter of 2017, following an increase of 3.2% in the third quarter and a 3.1% increase in the second quarter.
The outlook for continued economic expansion appears likely as the average consensus forecast for GDP growth in the first quarter of 2018 is 2.5% and the full-year forecast is 2.7%. Growth will be supported by financial conditions in the United States, which remain highly accommodative. The Federal Reserve Bank of Chicago publishes a weekly index that measures more than 105 variables to gauge how loose or tight financial conditions are in U.S. capital markets as well as the traditional and shadow banking systems. These variables include credit availability and cost, leverage, risk, interest rates, and credit spreads. Index levels above zero indicate tighter-than-average conditions, whereas levels below zero represent looser-than-average conditions. The National Financial Conditions Index is currently indicating that financial conditions are their loosest since October 1994.
Investors Continue to Pull Assets Out of High-Yield Funds While Credit Spreads Narrow Further
Investors continued to pull assets out of the high-yield market as credit spreads narrowed. For the week ended Jan. 24, high-yield open-end funds and exchange-traded funds experienced a net outflow of $1.0 billion, consisting of $0.3 billion of withdrawals from the open-end funds and $0.7 of unit redemptions from the ETFs. This outflow follows $3.5 billion in outflows the prior week. That weekly outflow was the third-highest registered over the past year and the fourth-greatest of the past two years.
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