High-Yield Credit Spread Rivals Tightest Levels Since Before Global Financial Crisis
As investors chased risk asset prices higher, bond prices in the U.S. Treasury market weakened.
The ongoing trade spat with China has not been able to derail investor enthusiasm for risk assets, and corporate credit spreads continued to tighten last week. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) tightened 3 basis points to end the week at +110. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 4 basis points to end the week at +325. Across other asset markets, equities continued their upward march as the S&P 500 rose 0.85% to a new high, oil prices surged almost $2 per barrel to $70.72, and copper spiked $0.23 per pound to $2.85.
The high-yield market has historically had a closer correlation to movements in the equity market than the investment-grade market, which has had a closer correlation to movements in interest rates, and this time is no different. As the equity market has continued its ascent to new highs, the average spread of the high-yield market has reached its tightest levels of the year, as well as the tightest that it has traded at since before the 2008-09 global financial crisis. Year to date, the average spread in the high-yield market has tightened 38 basis points.
However, after hitting its tightest levels since the 2008-09 global financial crisis earlier this year, the average credit spread in the investment-grade market backed up as interest rates surged higher across the entire yield curve. While the high-yield market has tightened this year, the average spread in the investment-grade market has widened 13 basis points. Between rising interest rates and wider credit spreads, investment-grade bonds have lost money for investors this year. The year-to-date return for the Morningstar Corporate Bond Index is negative 2.36%. With its shorter duration, the high-yield market is not affected as much by rising interest rates, and with high-yield spreads tightening, the high-yield index has risen 2.34%.
As investors chased risk asset prices higher, bond prices in the U.S. Treasury market weakened, pushing yields up to their highest levels in years. The yield on the 2-year Treasury rose 2 basis points to 2.80% last week and has risen a total of 92 basis points this year. At its current rate, the yield on the 2-year is at its highest yield since mid-2008. The 5-year Treasury yield rose 5 basis points to 2.95%, also its highest since mid-2008, and is now closing in on the 3% psychological ceiling that the 10-year bond finally broke though. The yield on the 10-year Treasury rose 6 basis points last week to 3.06% and has risen 65 basis points thus far this year. The last time the 10-year traded sustainably above 3% was in mid-2011. At the longest end of the yield curve, the 30-year Treasury rose 7 basis points to 3.20% and has risen 46 basis points this year.
The Federal Open Market Committee meets this week, and based on the current market-implied probabilities for additional hikes to the federal-funds rate, it appears that the market believes it is a foregone conclusion that the Federal Reserve will hike the federal-funds rate another 25 basis points to 2.00%-2.25% from its current 1.75%-2.00%. Following this hike, according to the CME FedWatch Tool, the market is pricing in an 86% probability of an additional hike following the December FOMC meeting to over 2.25%. According to market pricing, the Fed will have at least one more rate hike in store for 2019 and possibly two. The futures market is pricing in an 81% probability that the fed-funds rate will end 2019 at 2.50% or higher and a 46% probability it will be 2.75% or higher.
Weekly High-Yield Fund Flows
Net fund inflows into the high-yield asset class last week reversed the outflows of the prior week. The total amount of inflows was $0.9 billion, consisting almost entirely of net new unit creation among high-yield exchange-traded funds as the amount of inflows among high-yield open-end mutual funds was essentially zero. Typically, fund flows among exchange-traded funds have been considered to be indicative of institutional investor demand, whereas fund flows in open-end high-yield funds are representative of individual investor demand. Year to date, fund flows have registered a total outflow of $14.8 billion, consisting of $2.5 billion of net unit redemptions across ETFs and $12.3 billion of redemptions among open-end funds.
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