A Tale of Two Bond Markets
Investment grade struggles while high yield strengthens.
It's been a tale of two corporate bond markets thus far this year. Year to date, the Morningstar Corporate Bond Index (our proxy for the investment-grade market) has lost 3.14%, whereas the BofA Merrill Lynch High Yield Master Index has risen 0.66%. Since the beginning of the year, credit spreads have widened 24 basis points in the investment-grade market but tightened 30 basis points in the high-yield market. The average credit spread in the investment-grade market remains near its widest level thus far this year and is as high as it was this time last year. In contrast, the average credit spread of the high-yield index has rallied to its tightest level since before the 2008-09 credit crisis. To put into context just how tight spreads in the high-yield market are, since the beginning of 2000, the high-yield index has traded below the current level less than 9% of the time. Compounding the loss in the investment-grade market, with its longer duration, the investment-grade bond index is more sensitive to rising interest rates than the high-yield index. Since the end of last year, interest rates have risen significantly as the 2-year, 5-year, 10-year, and 30-year bonds have risen 67, 59, 51, and 31 basis points, respectively.
While a multitude of concerns have kept investors at bay in the investment-grade market, the most recent is the expectation that large-scale mergers and acquisitions will re-emerge in the near term. Last week, a court ruled against the Department of Justice's attempt to block the proposed merger between AT&T and Time Warner. This was a closely watched case, and this precedent is expected to open the floodgates to a deluge of M&A across the telecom and media sectors. As soon as the DOJ announcement was made, Comcast commenced a bidding war by offering to acquire certain assets from Fox for which Disney had made a prior offer. The loss by the DOJ is likely to affect other industries as well. Many rumored mergers contemplated over the past few years never came to fruition as management teams had assumed that the deals would not pass antitrust regulators. With the approval of the AT&T-Time Warner merger, many of these plans may be dusted off and brought to bear.
Historically, investment-grade bonds have been more negatively affected by M&A than high yield. Mergers and acquisitions are typically funded with significant amounts of newly issued debt, which often leads to downgrades. However, more often than not, high-yield companies are purchased by larger, investment-grade companies, and the outstanding debt of those acquired high-yield companies is upgraded to the same rating as the acquirer.
Thus far this year, the high-yield market has been the beneficiary of an acceleration in economic activity. With economic metrics coming in stronger than expected, as of June 14, the Federal Reserve Bank of Atlanta increased its GDPNow estimate for second-quarter GDP growth to 4.8%. This would be the second-strongest quarterly rate over the past four years, surpassed only by the third quarter of 2014. This added economic growth would be a tailwind to the credit metrics of more economically sensitive companies.
Following the hike to the federal-funds rate to 1.75%-2.00%, short-term rates continued their march higher. However, long-term rates have remained stubbornly flat, which has led to a further flattening of the yield curve. On the shorter end of the curve, the yield on the 2-year Treasury bond rose 5 basis points to 2.55%, matching the highest yield this year and the highest yield the 2-year has registered since mid-2008. Along the longer end of the curve, after breaking above the 3% psychological barrier a few weeks ago, the 10-year has rallied once again, sinking below that threshold and ending the week at 2.92%. The spread between the 2-year and 10-year Treasury has tightened to 37 basis points, representing the flattest the yield curve has been since fall 2007.
The yield curve has been on a multiyear flattening trend since the Federal Reserve began to raise short-term rates in its aim to normalize monetary policy. As short-term rates have risen faster than long-term rates, the steepness of the yield curve has flattened to its lowest level since before the 2008-09 credit crisis. In the past, when the yield curve has been flattening, it has often been an indicator of a weakening economy and in many cases an impending recession. This time around, this signal may not be foreshadowing a near-term recession risk, as it is being heavily influenced by global central bank actions and current economic activity hasn't shown any indications of slowing. In fact, as an indication of the current economic strength, the Atlanta Fed's GDPNow forecast of 4.8% for second-quarter real GDP growth would be a strong acceleration from 2.3% growth in the first quarter and the strongest quarterly growth rate since the third quarter of 2014.
In the short end of the curve, interest rates have been rising in connection with the hikes that the Fed has conducted this year, with the market pricing in an additional two rate hikes before year-end. According to the CME FedWatch Tool, the futures market is pricing in probabilities of 94% that the federal-funds rate will end the year at 200 basis points or higher and 55% that the fed-funds rate will end the year at 225 basis points or higher.
While the Fed's monetary policy actions have been directly affecting short-term rates in the United States, rates in other developed markets continue to be influenced by their central bank interventions. For example, at its most recent press conference, the European Central Bank disclosed its plans to keep its deposit rate at a negative yield of 0.40% through the summer of 2019. Furthermore, although the ECB announced that it will begin to taper its asset purchases this fall, it will continue to purchase EUR 30 billion of debt securities per month through September and then reduce the purchases to EUR 15 billion per month until the end of the year. Even though the 10-year U.S. Treasury is yielding only 2.92%, that yield has been attractive to global bond investors as the yield on Germany's 10-year bond is 0.40%, and the yield on Japan's 10-year bond is 0.04%.
June OPEC Meeting to Weigh Production Increases vs. Price Stability
Media reports indicate that Saudi Arabia and Russia have already agreed to increase oil output ahead of a much-anticipated discussion about the oil production cut agreement at the regularly scheduled OPEC meeting June 22. The question is how much. An opening of the spigots by the cartel and other participants—an expectation that has caused the Brent-basis oil price to decline to $73 per barrel from an interim peak of about $80 in May—would probably hamper further near-term pricing gains and have significant fiscal implications for export-oriented oil countries. According to the International Monetary Fund, Saudi Arabia needs the oil price to average near $88 this year to balance its state budget. The fiscal break-even oil price seems to provide Saudi Arabia and other export-oriented producers an incentive to carefully consider the merits of loosening curbs on production, lest a meaningful portion of pricing gains for the past 18 months be lost. --Contributed by Andrew O'Conor
Weekly High-Yield Fund Flows
Fund flows in the high-yield asset class registered a small net inflow of $0.3 billion last week. This was driven by net unit creation among exchange-traded funds as the amount of flows across high-yield open-end mutual funds was essentially unchanged. Year to date through June 13, there has been a total of $14.1 billion of outflows across the high-yield sector. Net fund flows have consisted of $9.7 billion of outflows among open-end high-yield mutual funds but only $4.4 billion of net unit redemptions among high-yield ETFs. Historically, open-end mutual funds have been viewed as a proxy for retail investors, while ETFs are considered a proxy for institutional investors.
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