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Credit Insights

Corporate Bonds Start 2019 With Strong Performance

So far this year, investment-grade and high-yield bond indexes have outpaced government bonds.

In the investment-grade corporate bond market, the average spread of the Morningstar Corporate Bond Index tightened 5 basis points to +130 last week. In the high-yield market, the average credit spread of the ICE BofAML High Yield Master Index tightened 5 basis points to +429. Since the end of last year, investment-grade spreads have tightened 27 basis points and high-yield spreads have tightened 104 basis points.

The rally among corporate bonds has propelled both the investment-grade and high-yield bond indexes to strong returns thus far this year, well outpacing the return in government bonds. Through last Friday, the Morningstar Corporate Bond Index has risen 2.20% and the ICE BofAML US High Yield Master Index has risen 4.72%, whereas the Morningstar US Government Bond Index has only increased 0.16%.

While Treasury bonds rallied last week, year-to-date interest rates have generally only returned to the levels where they began the year. Across the short end of the yield curve, it appears that the multiyear trend of rising rates will pause in the near term. Following the Federal Open Market Committee meeting last week, Federal Reserve Chair Jerome Powell said the case for further raising the federal-funds rate has weakened. Myriad economic risks have cooled the Fed's outlook. Although the Atlanta Fed's GDPNow forecast for first-quarter GDP growth is 2.5%, economists are concerned that contagion from slowing growth in Europe (for example, Italy, the European Union's third-largest economy, has officially entered a recession with two consecutive quarters of economic contraction) and weakening in China may negatively affect U.S. economic growth. In addition, poor weather conditions in the Midwest and the impact of the government shutdown have heightened the downside risk to economic growth in the first quarter. Economic growth also could be damped by ongoing trade disputes, a potential hard Brexit without a trade agreement, and the potential for additional U.S. government shutdowns if Congress and the executive branch are unable to reach an agreement on spending.

Over the past month, there has been a sizable shift in expectations regarding the amount and timing that the Fed may hike the federal-funds rate in 2019. According to the CME's FedWatch Tool, the market-implied probability that the federal-funds rate will end 2019 unchanged at the current range of 2.25%-2.50% rose to 86% from 66% just one week ago. As of last Friday, there is only a 3% probability that the Fed will hike short-term rates over the course of the year, whereas last week there was a 26% probability that the Fed would increase rates at least once. One of the more significant changes in the futures market is the increase in the probability that the Fed will cut interest rates by the end of the year. The probability that the Fed will cut interest rates this year has increased to 10% from only 4% last week.

Recent Research from Morningstar Credit Ratings: Consumer Defensive Sector
Last week, Wesley Moultrie, our analyst covering the consumer defensive sector, published the Consumer Defensive Sector Quarterly Credit Trend and Spread Chartbook. Over the past quarter in the consumer defensive space, MCR upgraded one firm and affirmed the ratings of eight companies.

In the packaged foods and nonalcoholic beverages subsector, Moultrie notes that operating earnings improvement has slowed for most packaged food firms that Morningstar covers, as benefits of extensive restructuring programs and cost-saving initiatives, which have generally resulted in greater profitability, are being absorbed by higher packaging and distribution costs and incremental brand investment. However, he expects the higher costs to be passed to consumers. Generally, debt leverage across the subsector remains high as most companies have recently engaged in M&A activities, but he expects debt leverage will moderate over time.

Across the restaurant sector, after mid- to high-single-digit growth over the past few years, same-restaurant sales growth has slowed, but operating margins remain strong thanks to structural improvements. From a macroeconomic perspective, an expanding economy, lower unemployment, and higher real wages have led to an increase in food consumed away from home; as a result, Moultrie anticipates continued increased spending on food service and restaurants.

Weekly High-Yield Fund Flows
High-yield fund flows were essentially unchanged last week as outflows among high-yield exchange-traded funds just barely edged out inflows across high-yield open-end mutual funds. Year to date, total inflows into the high-yield asset class are $3.9 billion, consisting of $2.5 billion of net unit creation among high-yield exchange-traded funds and $1.4 billion of inflows across high-yield open-end mutual funds.

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.