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Credit Insights

Corporate Credit Spreads Widen, but Only Back to 2018 Average

Turmoil in the equity market spurred a flight to safety.

Rising interest rates, tightening monetary policy, and contagion from heightened Italian sovereign risk took their toll on the U.S. equity market last week. The S&P 500 fell as much as 5.45% by the close Thursday before rallying Friday, ending the week with a 4.10% loss compared with the prior week. Since its recent high reached Sept. 20, the index has dropped 6.90%. While this pullback has been swift, in a longer-term context, the retreat only brings the index back to the same level it was in July. It still registers a gain of 3.50% for the year.

While demand for corporate bonds provided support to hold credit spreads steady at the end of September and beginning of October, investors in the corporate bond market succumbed to the risk-off sentiment permeating global equity markets. As such, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) widened 4 basis points to +113 last week. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 22 basis points to +354. The investment-grade and high-yield indexes are currently at their average spread levels for the year to date.

After steadily declining for much of this year, prices for U.S. Treasury bonds rebounded last week as the turmoil in the equity market spurred a flight to safety. The yield on the 2-year Treasury declined 3 basis points to 2.85%, the 5-year declined 6 basis points to 3.01%, and the 10-year and 30-year both fell 7 basis points to 3.16% and 3.33%, respectively. However, the volatility in the equity market failed to meaningfully change investors' view that the Federal Reserve will continue to raise the federal-funds rate. According to the CME's FedWatch Tool, the market-implied probability of a quarter-point hike following the December Federal Open Market Committee meeting declined only 2 percentage points to 80%. The market-implied probability of another hike in 2019 is 85%, and the probability of two additional hikes next year remains above 50%.

After falling steadily since the end of September, European stock markets saw their decline accelerate last week. Italy's FTSE MIB declined 5.36%, Germany's DAX dropped 4.86%, France's CAC declined 4.91%, and Spain's IBEX fell 3.80%. Year to date, most of the European equity markets have fallen enough to be considered in a correction, and if the market continues its downward trend, several of the indexes will soon close in on bear territory. Thus far this year, Italy has dropped 15.40%, Spain has fallen 14.50%, Germany has declined 13.48%, and the United Kingdom has decreased 9.43%, whereas France has only fallen 6.85%.

In addition to weakness in the equity markets, prices for Italian sovereign bonds continued their rapid decline, sending yields to their highest levels in years. Italy's 10-year bond rose another 16 basis points to 3.58% and is now trading 308 basis points higher than Germany's 10-year bond. To put this in perspective, the average spread level for the BB component of the ICE BofAML index is only +237. Italian bonds have been under significant selling pressure for the past few months as investors are becoming increasingly concerned about the country's finances. Italian bond prices plummeted following Italy's announcement that its budgeted deficit for 2019 would breach the European Union's limit. Currently, Italy's debt/GDP ratio is the second highest in the EU, surpassed only by long-beleaguered Greece. 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.

Recent Morningstar Credit Ratings Research
Last week, our healthcare team published its most recent Healthcare Quarterly Trends and Chartbook. This publication highlighted that pharmaceutical pricing dynamics remain under close regulatory scrutiny. As part of this scrutiny, regulators have identified the elimination of rebates as a way to try to protect consumers. However, even if this dynamic were to change, our team thinks the elimination of those rebates would not have a meaningful impact on the credit quality of the industry participants in the pharmaceutical supply chain. Credit quality has generally been holding steady across the sector; over the past quarter, there have been two changes on issuer outlooks. We revised our outlook on LabCorp (BBB+, stable) to stable from negative and Thermo Fisher (BBB, positive) to positive from stable.

In the basic materials sector, we published research reports on Nucor (A-, stable) and Steel Dynamics (BB+, positive). According to Sean Sexton, our basic materials analyst, Nucor's A- corporate credit rating reflects its moderate Business Risk profile, strong Cash Flow Cushion and Distance to Default scores, and very strong Solvency Score. Nucor uses lower-cost electric arc furnaces to produce a wide variety of steel products that service all major end markets; its use of these furnaces combined with its low-cost feedstock supply supports the company's positioning on the low end of the industry cost curve. Nucor has conservative financial policies and is consistently free cash flow positive throughout the cycle. Steel Dynamics' BB+ rating is supported by the company's low-cost operating profile in the volatile steel industry coupled with its growth ambitions and long-term leverage target of net debt/EBITDA of 3 times or less. The company is a relative newcomer to the steel industry and has some of the most modern and efficient mills in the business. It has a very low operating cost structure and higher productivity than many of its peers because it produces steel in electric arc furnaces, which are less capital-intensive, consume less energy, and provide greater operational flexibility than traditional blast furnaces.

Weekly High-Yield Fund Flows
Two weeks ago, we noted that after a several-month hiatus, volatility was returning to the high-yield market, and last week was no exception. As corporate credit spreads blew out, institutional investors headed for the hills and dumped high-yield exchange-traded funds en masse. Net outflows across the entire high-yield asset class totaled $4.9 billion, the second-largest outflow over the past year, trailing the outflows in February when the S&P 500 had dropped a little over 10% over a two-week time frame. The main difference this time around was that the preponderance of outflows occurred in high-yield ETFs, which suffered $4.3 billion of net unit redemptions; open-end funds experienced net withdrawals of only $0.6 billion. ETFs are typically considered a proxy for institutional investors as opposed to open-end funds, which are a proxy for individual investors. Part of the divergence in outflows this past week may be explained by the year-to-date fund flows of these two types of investment vehicles. Year to date, there has been $11.3 billion of withdrawals across open-end high-yield funds, but even after this past week's performance, there has been only $2.5 billion of net unit redemptions across high-yield ETFs.

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