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Credit Insights

Turbulence Settles by End of Week; Credit Spread Performance Mixed

Investors no longer felt the need to hide in U.S. Treasuries.

The closing week-over-week levels across many asset markets were either mixed or relatively unchanged by the end of last Friday, as much of the daily volatility that occurred earlier in the week dwindled. As the turbulence settled, investors no longer felt the need to hide in U.S. Treasuries, and as demand diminished, Treasury prices resumed their decline. By the end of the week, the yield on the 2-year had risen 5 basis points to 2.90%, its highest since June 2008, and the yield on the 5-year increased 5 basis points to 3.05%, its highest since August 2008. In the longer end of the curve, the 10-year rose 3 basis points to 3.19% and the 30-year increased 5 basis points to 3.38%.

In the corporate bond market, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) widened 2 basis points to +115 last week. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 3 basis points to +351. As we have highlighted several times this year, rising interest rates have played a significant part in the divergence between the performance of the investment-grade and high-yield markets. With their lower credit spreads and longer average durations, investment-grade bonds' performance is more closely correlated to movements in interest rates than high-yield bonds. High-yield bonds typically have shorter durations and wider credit spreads, which are more closely tied to the performance of the underlying companies.

To put the credit spread levels into context, both are not trading that far from their recent averages. Since the beginning of 2017, the spread in the investment-grade sector has ranged between +88 on Feb. 2, 2018, and +129 on June 28, 2018, resulting in an average of +109. In the high-yield sector, since the beginning of 2017, the index spread has ranged between +416 on March 22, 2017, and +316 on Oct. 3, 2018, resulting in an average of +366.

Among the global equity markets, the S&P 500 was essentially unchanged, Germany's DAX rose 0.26%, France's CAC fell 0.22%, and Spain's IBEX declined 0.11%. The only outlier was Italy's MIB, which continued its descent, falling another 0.91%. In the European sovereign debt market, after weakening all week, Italian bond prices rallied Friday afternoon after the Italian government signaled that it may revise its 2019 budget in order to reduce its forecast deficit. The yield on Italy's 10-year bond had weakened earlier in the week, but after a 20-basis-point rally Friday, it ended the week at 3.48%. Italian bond prices have been steadily falling since May, and the decline quickened over the past month after the government disclosed its original 2019 budget, which would breach the European Union's limit. As bond prices fell, yields spiked, reaching levels that they had last traded at in 2014 when the bonds were recovering after the European sovereign debt and banking crisis began to subside.

Recent Morningstar Credit Ratings Research
Last week, our industrials team published its most recent Corporate Credit Spread Chartbook. In this publication, it highlighted that its optimistic view for the industrials sector has ebbed slightly as of late. Although it still thinks the economic furor over the president's enacted tariffs on steel and aluminum and resulting trade war concerns are probably overblown, it may have seen an early, disconcerting warning from the sector's most influential leading indicator, the Institute for Supply Management Purchasing Managers' Index, a diffusion index. Although September's reading of 59.8 remained strongly in positive territory, the index was down 150 basis points from August's level. Moreover, the new orders component contracted 330 basis points sequentially, and our team thinks it could indicate further softening. Morningstar Credit Ratings will look to future movements in both the new order and inventory components of the PMI for further direction, but given the large exposure to energy, as long as the price of oil remains robust, the team expects the diversified industrial economy to motor along. In addition, our consumer team published its consumer defensive sector Quarterly Credit Trend and Spread Chartbook. In this publication, it noted that excluding firms engaged in M&A, MCR expects credit quality to improve modestly for the consumer defensive sector in the near term, driven mainly by higher operating earnings, cash flows, and debt reduction.

Among other research, we published a credit summary on Commercial Metals (BB+, stable). According to Sean Sexton, our basic materials analyst, the BB+ corporate credit rating reflects the company's moderate financial leverage, size, and competitive position in the cyclical steel industry and its desire for growth. The company's credit pillars include high Business Risk and moderate risk profiles for Cash Flow Cushion, Solvency Score, and Distance to Default. In the healthcare sector, Julie Utterback published a research report that compared the credit profiles of LabCorp (BBB+, stable) and Quest (BBB+, stable). LabCorp and Quest enjoy enviable positions at the top of the highly fragmented U.S. diagnostic testing market. We believe the similar-size companies enjoy scale-related advantages in that market that give them both narrow moats, according to Morningstar's Equity Research Group. LabCorp and Quest operate with slightly different concentration risks and leverage targets, but those factors largely offset in our methodology. LabCorp's contract research services that were acquired through Covance and Chiltern make it slightly larger and more diverse than Quest. However, Quest manages its balance sheet in a more conservative fashion. Those offsetting factors contribute to very similar credit risks at each firm, and although we see event risk potential on the horizon, we view both firms' credit trajectories as stable.

As third-quarter earnings season kicks into full gear, we published credit notes on Valero Energy (BBB+, stable), Novartis (AA, stable), Abbott Laboratories (A-, positive), Prologis (A-, stable), and Johnson & Johnson (AAA, stable).

Weekly High-Yield Fund Flows

After a staggering $4.9 billion outflow across high-yield funds the prior week, many institutional investors reversed course last week. Among high-yield exchange-traded funds, inflows amounted to $1.4 billion. ETFs are typically considered a proxy for institutional investors as opposed to open-end funds, which are a proxy for individual investors. Across open-end funds, investors withdrew $1.2 billion of assets from the high-yield space, which resulted in a net inflow of only $0.2 billion for the week.

Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization ("NRSRO"). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com.