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Credit Insights

Volatility Resurgence Sends Corporate Credit Spreads Wider

The corporate bond market had myriad issues to deal with this past week.

After appearing to dissipate in the second half of February, volatility made a resurgence at the end of the month. On one hand, investors are frightened of incurring losses as valuations are stretched thin and many pundits are warning of large retracements. On the other hand, investors are also influenced by FOMO--fear of missing out--as the historically successful buy-the-dip mentality has been ingrained in their psyche over the years.

This past week, the corporate bond market had myriad issues to deal with, consisting of technical issues relating specifically to the corporate bond market as well as much broader macroeconomic issues, potential changes to monetary policy, and the implications of potential trade disputes caused by tariffs. On the technical side, new issue volume surged and weighed on corporate credit spreads as the market tried to digest the heightened supply in the face of a retrenchment in the equity markets and rise in volatility. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 5 basis points to end the week at +105. In the high-yield market, the average spread of the BofA Merrill Lynch High Yield Master Index rose 7 basis points to +365. According to Bloomberg, over $35 billion of investment-grade bonds priced last week--the second-highest weekly amount thus far this year. Bloomberg noted that this volume weighed on the market and that some of the transactions traded wider in the secondary market.

On the economic front, several economic metrics were released. The second estimate for real GDP in the fourth quarter of 2017 was lowered to 2.5% from 2.6%. While economic growth dwindled going into the end of the year, however, it appears to be picking up in the middle of the first quarter. For example, the PMI held relatively steady at 55.3, a slight decrease from the 55.5 reading the prior month, but one that still indicates steady economic expansion (readings above 50 indicate economic expansion, whereas readings below 50 indicate contraction). However, the ISM Manufacturing Index soared to a 13-year high of 60.8 from 59.1, in stark contrast to the consensus estimate, which predicted a small downward reading. After incorporating the ISM reading and accounting for increases in estimates for real consumer spending growth and first-quarter real private fixed-investment spending, the Atlanta Federal Reserve raised its GDPNow model estimate for the first quarter of 2018 to 3.5% from 2.6%.

On the monetary policy front, newly appointed Federal Reserve Chairman Jerome Powell provided testimony and answered questions before the House Financial Services Committee as well as the Senate Committee on Banking, Housing, and Urban Affairs. In his prepared remarks, Powell highlighted the solid pace of economic growth in the second half of 2017, low unemployment rate, and stable inflation. He said, "The economic outlook remains strong. The robust job market should continue to support growth in household incomes and consumer spending, solid economic growth among our trading partners should lead to further gains in U.S. exports, and upbeat business sentiment and strong sales growth will likely continue to boost business investment. Moreover, fiscal policy is becoming more stimulative." With this statement as well as answers to questions in which he said he expected inflation to accelerate toward the Fed's 2% target, the markets took his comments as an indication that the Fed may raise interest rates more this year than had been generally anticipated. According to the CME FedWatch Tool, the probability that the federal-funds rate at the end of 2018 will be greater than 1.75% is 95%, the probability that the federal-funds will be 2% or higher is 73%, and the probability that the rate will be 2.25% or higher (representing four rate hikes) is now 31%. At the beginning of the year, those probabilities were 79%, 44%, and 13%, respectively. In the near term, the probability is 83% that the Fed will lift rates to 1.50%-1.75% after the March 20-21 Federal Open Market Committee meeting. In conjunction with the March meeting, the Fed will release an updated version of its Summary of Economic Projections, which will be scrutinized for any change in the dot plot graph that details FOMC participants' assessments of the midpoint of the target range for the federal-funds rate at the end of 2018. At the December 2017 meeting, the average projected federal-funds rate of the board members for the next three years was 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020. Powell will also conduct a press conference to make a statement and answer questions.

On the political front, investors are trying to divine the implications of potential tariffs on steel and aluminum imports and whether this is the first shot in a larger trade battle if other governments begin to retaliate. The yield on the 2-year Treasury note ended the week unchanged at 2.24%, the 5-year Treasury note rose 1 basis point to 2.63%, the 10-year Treasury bond was unchanged at 2.87%, and the 30-year Treasury bond declined 2 basis points to 3.14%. The spread between the yield on the 2-year and the 10-year Treasury was similarly unchanged at 63 basis points.

High-Yield Outflows Setting New Records
While the amount of outflows among high-yield open-end funds and exchange-traded funds for the week ended Feb. 28 was only a net negative $0.1 billion, it marked the seventh consecutive week of outflows. Since we began tracking high-yield fund flow data in 2009, this is a record for the highest number of consecutive weekly outflows for high-yield open-end funds and ETFs. Before this, there had only been two instances in which fund flows were negative for six consecutive weeks: December 2014 through January 2015 and July through August 2015.

In addition, there has been a total of $14.6 billion of outflows over the past seven consecutive weeks. This is also a record for the amount of outflows over a period of consecutive weekly outflows. The second-highest amount of outflows over a period of consecutive weekly outflows was $12.3 billion over five weeks in mid-2014 and the third-greatest amount was $12.1 billion over five weeks in spring 2013.

For the week ended Feb. 28, investors pulled $0.4 billion out of high-yield open-end funds; however, for the second consecutive week, high-yield ETFs registered net new unit creation. The amount of net new unit creation among ETFs was $0.3 billion and totaled $0.8 billion over the past two weeks. Historically, fund flows in the open-end mutual fund category have been a proxy for individual investor sentiment, while fund flows in ETFs have been a proxy for institutional investors.

Over the past seven weeks, net redemptions in the high-yield asset class totaled $14.6 billion, consisting of $7.8 billion of outflows in the open-end mutual fund category and $6.8 billion of net unit redemptions among the high-yield ETFs. Year to date, net redemptions in the high-yield asset class total $12.1 billion. Total outflows in the open-end mutual fund category are $6.5 billion and outflows registered among the ETFs are $5.6 billion.

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