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Credit Insights

High Yield Outperforming Investment Grade Year to Date as Credit Spreads Widen and Rates Rise

Several factors have led to this divergence.

Corporate credit spreads widened across both the investment-grade and high-yield sectors last week, although thus far this year the typically more stable investment-grade sector has underperformed the high-yield sector. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 4 basis points last week and has widened 13 basis points this year. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 7 basis points last week but year to date remains 3 basis points tighter. Between the divergence in corporate credit spreads and the impact of rising interest rates, the high-yield index's total return has outperformed that of the investment-grade index. Through March 16, the Morningstar Corporate Bond Index has declined 2.64%, whereas the BofA Merrill Lynch High Yield Master Index has declined only 0.65%.

Several factors have led to this divergence. Investment-grade credit spreads are more susceptible to sell-offs in relation to debt-leveraged mergers and acquisitions, which have re-emerged as a significant risk to the investment-grade market. For example, CVS Health Corp. (BBB+/UR-) recently brought a $40 billion, multitranche new issue to market in order to fund its planned acquisition of Aetna, which is expected to close in late 2018. We had placed our rating for CVS under review with negative implications when the acquisition was announced, as we expect that the debt leverage of the combined company will increase to over 4 times. This new issue transaction is the third-largest single-borrower transaction in the history of the corporate bond market and has weighed on the primary as well as secondary markets. Since this deal was priced, new issue concessions in the primary market have been greater than normal in order to attract investor attention.

Between the new supply and the wider-than-usual new issue concessions, investors have little reason to bid up prices on other corporate 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. It appears that the appetite for acquisitions in the healthcare industry is not sated, as Cigna (non-NRSRO: BBB/UR-) recently announced its bid to purchase Express Scripts (A-/UR-).

Rising interest rates have also played a significant part in the divergence between the performance of investment-grade and high-yield credit spreads. With their lower credit spreads and longer average durations, investment-grade bonds' performance is more closely tied to movements in interest rates than that of high-yield bonds, which typically have shorter durations and wider credit spreads that are more closely tied to the performance of the underlying companies. Similar to the credit spread widening that occurred during the "taper tantrum" in mid-2013, investors are beginning to require additional credit spread to compensate for the risk that interest rates will rise further. Year to date, yields on the 2-, 5-, 10-, and 30-year U.S. Treasury bonds have risen 41, 43, 43, and 34 basis points, respectively. The pressure on corporate credit spreads has been especially pronounced in the short end of the curve. One Wall Street bond trader said, "Front-end paper remains for sale, causing credit curves to continue to flatten." (Front-end paper is industry jargon for short-term bonds.) The average spread in the 1- to 4-year tranche of the Morningstar Corporate Bond Index has widened 17 basis points thus far this year, whereas the 10-plus-year tranche has widened only 7 basis points.

Volatility across the asset markets in general has risen off 2017 lows, and the investment-grade market has historically been more correlated to changes in volatility than high yield. For example, the correlation between the VIX and the credit spread of the Morningstar Corporate Bond Index has been 85% over time, whereas the correlation between the VIX and the BofA Merrill Lynch High Yield Master Index has been much lower.

Compounding the pressures on the corporate bond markets, expectations for economic growth have been sliding. Since the beginning of March, the Atlanta Fed's GDPNow estimate for first-quarter real GDP has slipped to 1.8% from 3.5%. It had been as high as 4.2% in January, when the Atlanta Fed made its initial estimate for the first quarter. This forecast has been sliding as economic indicators have been decelerating. For example, the headline figure released last week for retail sales in February dropped 0.1% because of weak auto sales and lower gasoline prices, but even excluding the more volatile components, the control group rose only 0.1%. Expectations for retail sales were much higher going into this reading as economists expected the impact from tax cuts to boost consumption.

According to the CME FedWatch Tool, it appears that the market is pricing in a hike this week in the federal-funds rate as a foregone conclusion. The probability that the Federal Reserve will lift rates to 1.50%-1.75% after the Federal Open Market Committee meetings March 20-21 is 94%. The market is also pricing in additional hikes over the course of the year. The probability that the federal-funds rate at the end of 2018 will be greater than 1.75% is 96%, the probability that the fed-funds rate will be 2% or higher is 74%, and the probability that the rate will be 2.25% or higher is now 34%. At the beginning of the year, those probabilities were 79%, 44%, and 13%, respectively.

In conjunction with the March meeting, the Fed will release its updated summary of economic projections. These projections 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. According to projections from the Fed's December 2017 meeting, board members' average projected federal-funds rate is 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020. In addition, Fed Chairman Jerome Powell will conduct a press conference to make a statement and answer questions.

High-Yield Outflows Turn to Inflows by Slimmest of Margins
After a record-breaking eight consecutive weeks of outflows among high-yield open-end mutual funds and exchange-traded funds, fund flows turned positive last week, albeit by the slimmest of margins. Net inflows of $67 million broke the outflow trend as $473 million of net unit creation among ETFs outweighed the $406 million of outflows in open-end mutual funds.

Before this past week, there were eight consecutive weeks of net outflows in the high-yield sector, which surpassed the prior record of six weeks. Those periods occurred in December 2014 through January 2015 and again in July through August 2015. Year to date, there has been a total of $11.5 billion of outflows in the high-yield sector, consisting of $6.9 billion of outflows among the open-end high-yield mutual funds and $4.7 billion of net unit redemptions among the high-yield ETFs.

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