Corporate Bond Market Trying to Regain Its Footing
China's weaker-than-expected sales and production results exacerbated already dour market sentiment.
Credit spreads in the corporate bond market began on a strong note early last week but gave back some of the gains on Friday. Investor sentiment evaporated following weaker-than-expected economic data from China, heightened international trade tensions, and falling equity prices. Among the economic indicators released by Chinese officials, retail sales and industrial production were below expectations. While Chinese fixed-asset investment was in line with consensus, the weaker-than-expected sales and production results exacerbated the already dour market sentiment, which has been under pressure from the tense negotiations between the United States and China. Expectations for global growth were also tempered by the decline in the eurozone composite purchasing managers report. The index fell for the fifth consecutive month, to 51.3 from 52.7. While a reading above 50 indicates economic expansion, as opposed to a reading below 50, which indicates contraction, this most recent reading was the lowest of the past 49 months. Equity prices were pummeled Friday as the S&P 500 fell almost 2% for the day and ended the week 1.26% in the red. Year to date, the S&P 500 is down 2.76%.
Corporate bond credit spreads began the week on a strong note and snapped tighter through Thursday, then gave back some, but not all, of the gains on Friday. On a week-over-week basis, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) tightened 4 basis points to +145. In the high-yield market, the BofA Merrill Lynch High Yield Master Index also tightened 4 basis points to end the week at +446.
Although credit spreads tried to rebound last week, year to date the average spreads for investment-grade and high-yield corporate bonds have widened meaningfully and are at their widest levels since 2016. Thus far this year, the investment-grade index has widened 49 basis points and the high-yield index has risen 83 basis points. At these currently wider levels, on a longer-term scale, both indexes are moving toward their long-term averages. In the investment-grade market, the current spread level is 18 basis points below the long-term average of +163; however, that average is skewed to the upside due to the collapse of the bond markets during the 2008-09 global financial credit crisis. At the current spread level, the index is actually slightly higher than the median spread level as the index has traded below its current level over 50% of the time.
In the high-yield market, while spreads are rising toward the long-term average, they remain lower than both the long-term average and median. At its current level, the index spread is 144 points below the average and 80 basis points below the median. Since 1999, the index has registered a higher spread level about 65% of the time compared with now.
While prices on U.S. Treasury bonds rose toward the end of the week as investors sought refuge from the weak equity markets, the rebound was not enough to offset price declines earlier in the week. The yield on the 2-year U.S. Treasury bond rose 2 basis points to 2.73% and the yield on the 5-year increased 4 basis points to 2.73%, which erased the slight yield inversion the prior week. In the longer end of the curve, the 10-year rose 4 basis points to 2.89% and the yield on the 30-year was unchanged at 3.14%.
Although the markets have been relatively choppy, the increased volatility has not been enough to change investors' expectations for an additional rate hike this week. Recently released economic metrics, such as the retail sales report and the industrial production report, were enough to raise the Atlanta Fed's GDPNow model for fourth-quarter GDP to 3.0% (matching its highest reading this quarter) from 2.4% in its previous reading. In addition, while falling oil prices will put pressure on future inflation, inflation remains near the Federal Reserve's target. According to the CME's FedWatch Tool, the probability that the Fed will hike the federal-funds rate by another quarter point to 2.25%-2.50% is 77%. However, the probability that the Fed will hike rates again in 2019 is only slightly better than a coin flip. The market-implied probability that the federal-funds rate will end 2019 at 2.50% or higher is 55%. That probability was as high as 70% at the end of last month and 88% at the beginning of November.
Weekly High-Yield Fund Flows
The pace at which investors pulled money out of the high-yield asset class picked up speed last week as net fund outflows increased to $2.1 billion. Over the past three months, weekly fund flows have been negative 75% of the time compared with the year-to-date weekly fund flows, which have been negative a little over half the time. This past week was the ninth instance over the past year in which weekly fund outflows were $2.1 billion or more.
Outflows were reasonably balanced between open-end mutual funds and exchange-traded funds. Among open-end high-yield funds, investors withdrew $1.2 billion, and across high-yield ETFs, net unit redemptions totaled $1.0 billion. Year to date, total outflows across the high-yield sector have been decidedly negative. Thus far this year, investors have pulled $25.2 billion out of the junk bond market. Outflows among open-end funds are $16.9 billion and net unit redemptions in ETFs are $8.3 billion.
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