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Credit Insights

CVS Megadeal Weighs on Investment-Grade Corporate Bonds

The extremely strong employment report released Friday morning overwhelmed any lingering negative investor sentiment from the tariff debates and the resignation of Gary Cohn as director of the National Economic Council. Risk assets traded fairly well through most of the week, but equities soared Friday after it was reported that jobs jumped by 313,000 in February. The S&P 500 rose 3.54% for the week, but half of that increase came on Friday alone, when the index jumped 1.74%. Even though most classes of risk assets rose last week, credit spreads in the investment-grade corporate bond market languished and were generally unchanged as bond investors suffered a little indigestion from the monster $40 billion CVS Health (BBB+/UR-) deal.

This transaction from CVS was the third-largest single-borrower transaction in the history of the corporate bond market. The largest transaction was the $49 billion Verizon (BBB, stable) deal in 2013, in which the proceeds were used to finance the company's wireless assets. The second largest occurred in 2016, when Anheuser-Busch InBev (BBB+, stable) priced $46 billion to fund the purchase of SABMiller. CVS plans to use the proceeds from this transaction to fund its acquisition of Aetna, which is expected to close in late 2018. We placed our rating for CVS under review with negative implications when the acquisition was first announced, as we expect the debt leverage of the combined company will increase to over 4 times.

Given the size of the CVS issuance, corporate credit spreads in the investment-grade market were under pressure as the market digested this new supply. Compounding the overhang on the investment-grade market, other issuers that came to market had to pay greater-than-average new issue concessions to attract new investors to price their deals. Between the new supply and the wider-than-usual new issue concessions, investors have little reason to bid up prices on other bonds until this abundant supply is put away in long-term hands. In addition, investors are increasingly leery that the re-emergence of large debt-funded acquisitions will drive credit spreads wider for those companies. It appears that the appetite for acquisitions in the healthcare industry is not over, as Cigna (BBB/UR-) on Thursday announced its bid to purchase Express Scripts (A-/UR-).

The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) ended the week unchanged at +105. Credit spreads in the investment-grade market languished as the CVS deal cast a shadow across trading desks, while in the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 12 basis points to +353. There has been a record-setting eight consecutive weeks of outflows among high-yield open-end mutual funds and exchange-traded funds; however, the positive sentiment from the stunning jobs number more than offset the pall from continued redemptions.

Interest rates rose 2 basis points across the yield curve in a parallel shift upward. The 2-year Treasury note ended the week at 2.26%, its highest yield since September 2008. The yield on the 2-year has risen in lockstep with the expected increase in the federal-funds rate. Between the jump in employment and strong readings across other economic metrics such as the PMI and ISM indexes, investors are pricing in increasingly higher probabilities that strong economic growth will prompt the Federal Reserve to raise short-term rates even more than originally expected at the beginning of the year.

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 fed-funds rate 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 34%. At the beginning of the year, those probabilities were 79%, 44%, and 13%, respectively. In the near term, the probability that the Fed will lift rates to 1.50%-1.75% after the Federal Open Market Committee meetings March 20-21 is almost a foregone conclusion at 89%.

In conjunction with the March meeting, the Fed will release an updated summary of its economic projections, which will be scrutinized for any change in the dot plot graph that details FOMC participants' assessment of the midpoint of the target range for the federal-funds rate at the end of 2018. At the Fed's December 2017 meeting, the average projected federal-funds rate of the board members was 2%, 2.70%, and 3% for years ended 2018, 2019, and 2020. In addition, Fed Chairman Jerome Powell will conduct a press conference to make a statement and answer questions.

Across the rest of the yield curve, the 5-year Treasury note rose to 2.65%, the 10-year Treasury bond increased to 2.89%, and the 30-year Treasury bond ended the week at 3.16%. The spread between the yield on the 2-year and the 10-year Treasury was unchanged at 63 basis points.

High-Yield Outflows Continue to Set Records
Outflows in the high-yield asset class just would not stop; for the eighth consecutive week, high-yield open-end mutual funds and exchange-traded funds registered outflows. The prior record for consecutive weekly outflows was six weeks, which occurred in December 2014 through January 2015 and again in July through August 2015. Net outflows last week increased to $0.6 billion from $0.1 billion the prior week, with $0.4 billion of outflows among the open-end mutual funds and $0.2 billion of net unit redemptions across the ETFs.

There has been a total of $15.1 billion of outflows over the past eight weeks. This is also a new record for the amount of outflows occurring over a period of consecutive weekly outflows. The second-greatest amount of outflows that occurred 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.

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