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Credit Insights

Corporate Credit Spreads Sail Into Choppy Water

Corporate credit spreads tightened early in the week but ran into rough seas in the latter half of the week.

After relatively smooth sailing over the past three months, the corporate bond market encountered some choppy water at the end of last week. Corporate credit spreads tightened early in the week but, according to one Wall Street bond trader, ran into rough seas in the latter half of the week in sympathy with the decline in the equity market. After its seemingly relentless rise thus far this year, the stock market finally gave back some of its gains as the S&P 500 declined 3.16% last week, with the preponderance of the loss occurring at the end of the week. Even after this pullback, the equity index remains up 4.06% year to date.

Earlier in the week, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) declined 3 basis points to +88 basis points (its lowest level since before the global financial credit crisis) and held that level by the skin of its teeth through the end of Friday. The average credit spread of the investment-grade index is now 8 basis points tighter year to date and 40 basis points tighter than at the end of 2016. As a point of reference, the tightest the investment-grade index has ever registered was +80 basis points in February 2007. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 13 basis points to end the week at +336. The high-yield index remains 27 basis points tighter year to date, which is 85 basis points tighter than at the end of 2016. The tightest the high-yield index has ever registered was +241 basis points in June 2007.

Interest Rates Jump as Treasury Bond Prices Walloped
Treasury bond prices were walloped last week, sending yields across the yield curve to their highest levels in years. The yield on the 2-, 5-, 10-, and 30-year Treasury bonds rose by 2, 12, 18, and 18 basis points, respectively, to 2.14%, 2.59%, 2.84%, and 3.09%. The yield on the 2-year Treasury bond is its highest since September 2008, and the yield on the 5-year Treasury bond is its highest since 2009. Just this year alone, the yield on the 2-year bond has risen 26 basis points, and on the longer end of the curve, the 10-year has risen 43 basis points.

Based on the Federal Reserve's statements and its own interest-rate forecasts, as well as the heightened probability of 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 a 78% probability that the Fed will raise the federal-funds rate at its March meeting. The market is pricing in an 88% probability that the federal-funds rate at the end of 2018 will be greater than 1.75% and a 59% probability that the rate will be 2% or higher. According to the Fed projections from its December 2017 meeting, the board members' average projected federal-funds rate is 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020.

First-Quarter GDP Forecast to Soar 5.4%
Based on the GDPNow model forecast from the Federal Reserve Bank of Atlanta, real GDP growth at a seasonally adjusted annual rate is projected to increase 5.4% in the first quarter. This follows relatively moderate growth over the past few quarters, in which GDP rose 2.6% in the fourth quarter of 2017, 3.2% in the third quarter, and 3.1% in the second quarter. If the Atlanta Fed's model forecast comes to fruition, this would be the highest annualized growth rate recorded since the third quarter of 2003. Since the beginning of 2000, GDP has expanded at a 5% or greater annualized rate only three times.

Economic growth has been supported by highly accommodative financial conditions in the United States. As a gauge of how loose or tight financial conditions are among U.S. capital markets, the Federal Reserve Bank of Chicago publishes the National Financial Conditions Index, a weekly index that measures more than 105 market variables. Currently this index is indicating that financial conditions are their loosest since October 1994. The variables utilized by this index include credit availability and cost, leverage, risk, interest rates, and credit spreads.

Investors Pull Assets Out of High-Yield Funds for Third Consecutive Week
For the third consecutive week this year, investors pulled assets out of the high-yield market. For the week ended Jan. 31, high-yield open-end funds and exchange-traded funds experienced a net outflow of $1.2 billion. The outflows consisted of $0.4 billion of withdrawals from open-end funds and $0.8 of unit redemptions from ETFs. Over the past three weeks, outflows total $5.5 billion.

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.