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Credit Insights

Surging U.S. Interest Rates Hardly Dent Demand for Corporate Bonds

Corporate credit spreads on investment-grade corporate bonds held steady and high-yield bonds backed off slightly.

Interest rates in the United States have generally been on a gradually rising trend for the past few years as the Federal Reserve has been hiking them to normalize monetary policy. More recently, interest rates began rising after the European Union announced its plan to begin pulling back on its asset-purchase program in Europe. Then, following strong economic metrics and intimations from U.S. monetary policy officials that rates still have much further to rise, U.S. interest rates spiked significantly higher across the entire yield curve last week. The contagion sent interest rates higher across other sovereign bond markets as well.

While the yield on the 2-year Treasury rose only 6 basis points to 2.88% last week, the middle and longer ends of the curve rose much more. In the belly of the curve, the 5-year increased 12 basis points to 3.07%, and in the longer end, the 10-year increased 17 basis points to 3.23% while the 30-year spiked 19 basis points to 3.40%. The yields on both the 2- and 5-year bonds have long been steadily marching higher in conjunction with the rising federal-funds rate and are at their highest levels since mid-2008. While the yield on the 10-year has not increased as much as the shorter-dated bonds thus far this year, it is quickly catching up and is at its highest level since mid-2011.

Short-term rates will probably continue to be under pressure over the course of the next year. According to the CME's FedWatch Tool, the market is pricing in an 82% probability of a quarter-point hike following the December Federal Open Market Committee meeting. 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 89% probability that the federal-funds rate will increase to 2.50% or higher following the October 2019 meeting and a 61% probability that the federal-funds rate will be 2.75% or higher.

In Europe, prices for Italian sovereign bonds have been under significant selling pressure for the past few months as investors are once again increasingly concerned about the country's finances. Most recently, the bond prices plummeted following Italy's announcement that its budgeted deficit for 2019 would breach the EU's limit. Currently, Italy's debt/GDP ratio is the second highest in the EU, surpassed only by long-beleaguered Greece. While there was a slight rebound in September, Italian sovereign debt continued its downward trajectory last week. The yield on Italy's 2-year bond rose 32 basis points to 1.34%, and in the longer end of the curve, the yield on Italian 10-year bonds rose another 27 basis points to 3.42%.

Germany's 2-year bond still trades at a negative yield of 0.51%, and German 10-years trade at 0.57%. As an indication of the market's risk perception of Italian default or redenomination risk, the spread between Italian and German debt has widened to 285 basis points. The current rates for Italian sovereign debt rival the highest interest rates the bonds have traded at since mid-2014, when they were recovering from the Italian banking crisis. Contagion from rising rates generally, and the weakening Italian bonds specifically, has spread to the equity market in Europe. Italy's FTSE MIB declined 1.77% following the 3.72% drop it suffered the prior week. Germany's DAX dropped 1.10%, France's CAC declined 2.44%, and Spain's IBEX fell 1.44%.

While interest rates on sovereign bonds surged higher, corporate credit spreads on investment-grade corporate bonds held steady and high-yield bonds backed off slightly. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) tightened 1 basis point to +109 last week. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 8 basis points to +332.

Even with volatility poking its head out in the equity market, the investment-grade new issue market easily absorbed Comcast's (BBB+, negative) $27 billion multitranche offering. According to Bloomberg, this is the fourth-largest bond offering in the corporate investment-grade market. Proceeds from the offering will be used to fund the takeover of SKY plc (not rated). Morningstar Credit Ratings, LLC downgraded its corporate rating on Comcast to BBB+ on July 18 and moved the outlook to negative from stable. The downgrade reflected Comcast's weaker stand-alone Business Risk and Distance to Default scores, offset by a stronger Solvency Score and stable Cash Flow Cushion. The negative outlook recognizes the potential for additional pressure on Cash Flow Cushion and Solvency Score from the Sky acquisition.

MCR's rating on Bed Bath & Beyond (rating: BB+, negative) is one to two notches lower than the other credit rating agencies', and the company's recently released second-quarter earnings reinforced our negative outlook on the company's credit risk. The rating reflects MCR's outlook for weakening revenue, margins, return on invested capital, and lower free cash flow. While the company continues to experience strong sales from its online channels, which MCR estimates to be growing in the double-digit range, comparable sales at its stores fell in the mid-single-digit range. Gross margins declined compared with last year and were hurt by the faster growth of lower-margin online sales that we estimate to represent over 15% of total revenue. EBITDAR fell 19% to $315 million, and margins eroded 260 basis points to 10.7%. As a result, the company lowered its revenue and margin guidance for fiscal 2018.

Weekly High-Yield Fund Flows
After 12 months of relatively subdued volatility in net fund flows in the high-yield space, inflows came rushing back last week. Net inflows totaled $2.5 billion, consisting of $1.6 billion among high-yield exchange-traded funds and $1.1 billion of inflows across high-yield open-end mutual funds.

Year to date, fund flows have registered a total outflow of $13.8 billion, consisting of $2.5 billion of net unit redemptions across ETFs and $11.3 billion of redemptions among open-end funds.

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