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Credit Insights

2018 Fixed-Income Returns Pressured by Rising Rates, Widening Credit Spreads

Yield curve continues to flatten as rates rise.

Rising interest rates, especially at the long end of the yield curve, along with widening corporate bond credit spreads hampered fixed-income returns in 2018. Over the course of the year, the interest rate on 2-year, 5-year, 10-year, and 30-year U.S. Treasury bonds rose 61, 30, 27, and 27 basis points, respectively. The total annual return for Morningstar's Core Bond Index (our broadest measure of the fixed-income universe) was essentially unchanged at a 0.01% loss for the year. Breaking the overall index down, Morningstar's Short-Term Core Bond Index rose 1.46% and the Intermediate Core Bond Index rose 0.93%, but these gains were offset by the Long-Term Core Bond Index, which fell 3.24%. The amount that long-term bond prices fell due to rising rates more than offset the yield carry of the underlying securities.

In the corporate bond market, credit spreads widened out significantly across investment-grade and high-yield bonds. For the year, the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) registered a loss of 2.30%. In the high-yield sector, the ICE BofAML US High Yield Master II index declined 2.26%. Even though credit spreads widened out more in the high-yield sector, investment grade underperformed as it has a longer duration than the high-yield index and was more negatively affected by rising interest rates.

Emerging-markets fixed-income indexes were the worst performers for the year as negative investor sentiment drove interest rates higher and emerging bond credit spreads wider. The Morningstar Emerging Market Composite Index fell 2.82%, as the underlying Morningstar Emerging Market Sovereign Index declined 4.72% and the Morningstar Emerging Market Corporate Index fell 1.71%. Morningstar's Emerging Market High Yield Index dropped 4.61%.

Yield Curve Continues to Flatten as Rates Rise
In conjunction with the hikes in the federal-funds rate, short-term rates continued their march higher in 2018. The interest rate on the 2-year U.S. Treasury bond rose to almost 3% in mid-November, but then it rallied over the past two months to end the year at 2.49%, a 61-basis-point increase from the end of 2017. Similarly, the yield of the 10-year U.S. Treasury bond had risen to 3.24% before rallying and ending the year at 2.68%, an increase of 27 basis points over the course of the year. Treasury prices have rebounded slightly over the past few weeks as global asset markets deteriorated and volatility increased, sending many investors to the safety of U.S. Treasury bonds. For the year, the S&P 500 index fell 6.2% with the loss predominantly occurring over the last few weeks amid increasingly negative rhetoric surrounding global trade renegotiations and the rising risk that new tariffs and responding retaliatory tariffs will be imposed.

While short-term rates have surged higher this past year, the increase in long-term rates has lagged, leading to a further flattening of the yield curve. This drove the spread between the 2-year and 10-year Treasury tighter to 19 basis points, representing the flattest the yield curve has been since fall 2007. The yield curve has been on a multiyear flattening trend since the Federal Reserve began to raise short-term rates in its pursuit to normalize monetary policy. Historically, a flattening yield curve has often been an indicator of a weakening economy and in many cases portended an impending recession when the yield curve has inverted. This time around, this signal may not be foreshadowing a near-term recession risk, as it is being heavily influenced by global central bank actions. While some recent economic metrics have been weakening, they continue to indicate continued economic growth, just at a slower rate of expansion. According to the Atlanta Fed's GDPNow model forecast, fourth-quarter 2018 real GDP growth is running at an estimated 2.6% annualized rate.

After Trading Near Historically Tight Levels, Corporate Bond Credit Spreads Surge Higher Toward Long-Term Averages
In 2018, the average spread of the Morningstar Corporate Bond Index widened 60 basis points to +157 and the average credit spread of the ICE BofAML High Yield Master Index widened 170 basis points to +533.

Among the winners and losers for the year by sector, companies with defensive characteristics generally outperformed, whereas sectors that are more economically sensitive underperformed. For example, real estate investment trusts and healthcare widened out the least in 2018, while the manufacturing and energy sectors are among those that widened out the most.

At these currently wider levels, on a longer-term scale, both indexes are near their long-term averages. In the investment-grade market, the current spread level is only 5 basis points below the long-term average of +162; however, that average is skewed to the upside due to the collapse of the bond markets during the 2008-09 global financial credit crisis. If you compare the index with the median spread level, credit spreads are now wider than the median as the index has traded below its current level almost 60% of the time.

In the high-yield market, the average spread is 57 basis points below its long-term average; however, the current level is trading right at the median over the same period.

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