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Credit Insights

First-Quarter 2019 Fixed-Income Index Overview: Falling Interest Rates and Tighter Credit Spreads Drive Outsize Gains

The combination of declining interest rates and tightening credit spreads drove fixed-income markets higher across the board in the first quarter. Morningstar's Core Bond Index, our broadest measure of the fixed-income universe, rose 2.98% in the first quarter. Underlying the Core Bond Index, Morningstar's Short-Term Core Bond Index increased 1.48%, the Intermediate Core Bond Index rose 2.42%, and the Long-Term Core Bond Index surged by 5.82% this past quarter. In the Treasury market, the Morningstar U.S. Government Bond Index increased 2.17% and in the agency market, the Morningstar Agency Bond Index rose 2.06%. Even though inflation expectations remained relatively unchanged over the past three months, the Morningstar TIPS Index gained 3.29%.



The decline in interest rates across the entire yield curve drove the outsize gains in these indexes as compared with the underlying yield carry. After hitting its highest yield since mid-2008 last November, the interest rate on the two-year Treasury bond has been steadily declining. As contagion from slowing global economic growth seeps into the U.S. economy, the market-implied probability that the Fed will hike short-term rates higher has turned the corner. As recently as mid-December 2018, the market had priced in at least one more rate hike in 2019 whereas investors are now expecting at least one cut to the federal-funds rate if not two before the year is out. This change in expectations drove demand for U.S. Treasury bonds, especially in the belly of the curve. Since the end of last year, the yield on the two-,

Among European fixed-income indexes, returns lagged most of the other fixed-income markets as the Morningstar Eurozone Bond Index rose only 0.75%. The return was driven by the decline in underlying interest rates of benchmark German bonds, which have once again fallen into negative territory. The yield on Germany's benchmark 10-year bund ended the quarter at a negative yield of negative 0.07%. Among the benchmark sovereign bonds, U.S. Treasuries are some of the highest-yielding options. For example, the Swiss 10-year bond is trading at a negative yield of negative 0.38% and Japanese 10-year bonds are at a negative 0.08%. According to Bloomberg, over $10 trillion worth of global debt is trading at a negative yield, meaning that if an investor holds these securities until maturity, they will lock in a loss. The only way an investor could earn a positive return would be to sell those bonds at an even higher price to another investor, which means the second investor would be willing to lock in an even greater loss.

In the corporate bond market, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) rose 5.14% this past quarter as the combination of higher interest rates and tighter credit spreads pushed bond prices up. In the high-yield market, the ICE BofAML High Yield Master Index rose 7.38% in the second quarter as credit spreads tightened significantly since the selloff in November and December. Year to date, both the Morningstar Corporate Bond Index and ICE BofAML High Yield Master II Index have recovered a significant amount of the widening that occurred late last year. Thus far this year, investment-grade corporate bond spreads have narrowed by 35 basis points and high-yield spreads have tightened 134 basis points. In Europe, with interest rates at already negligible levels, the gains were muted as the Morningstar Eurobond Corporate Index rose only 1.53%.

As investors sought out higher returns and were willing to undertake greater risk, the emerging-markets fixed-income indexes were among the best-performing fixed-income asset classes following significant losses last quarter. In the first quarter, the Morningstar Emerging Market Composite Index rose 5.72%, as the underlying Morningstar Emerging Market Sovereign Index surged 6.44% and the Morningstar Emerging Market Corporate Index rose 5.33%. Morningstar's Emerging Market High Yield Index increased 6.09%.

Recent Morningstar Credit Ratings Research
Morningstar Credit Ratings, LLC published an overview of the real estate investment trusts in the U.S. that focus on providing their clients with data centers. With a combined market capitalization of over $68 billion, data center REITs are becoming an increasingly important sector within the REIT market. Within this report, we provide background data on the sector in general and specifically highlight credit metrics on the five largest publicly traded data center REITs.

Over the past five years, data center REITs have improved key margins on average as EBITDA margins have risen to 50.6% in 2018 from 46.7% in 2014. We note that due to the strong fundamental growth underlying the sector, that in order to increase capacity to meet growing demand, leverage has likewise increased; however, leverage has not risen to levels that we consider alarming. Since 2014, average debt/EBITDA rose to 5.8 times from 4.7 times, and debt/gross assets to 53.2% from 43.2%. Also, secured debt levels are negligible, implying a significant alternative liquidity resource if required by the operators by virtue of significant unencumbered portfolios that could be used as secured capital in the future. We also note that unlike many broader REITs, because of the inherent switching costs and network effect within the business, many of those in the data center space have long-term sustainable competitive advantages. For example, Morningstar's Equity Research Group has assigned narrow economic moats to three of the four data center REITs they cover. In our view, those data centers with an economic moat will be able to generate excess returns on invested capital over the next 10 years or more. For the full report, please visit Overview of U.S. Data Center REITs published March 25 and the accompanying webcast.

Weekly High-Yield Fund Flows
Net unit creation for high-yield exchange-traded funds accounted for all of the $0.5 billion of fund inflows into the high-yield sector last week. For first-quarter 2019, total inflows into the high-yield asset class is $11.7 billion, consisting of $6.6 billion worth of net unit creation among the high-yield ETFs and $5.1 billion of inflows across the high-yield open-end mutual funds. However, over the past 52 weeks, fund flows in the high-yield asset class remain decidedly negative. Across both the ETFs and open-end funds, total outflows over the past 52 weeks are $4.8 billion. The outflows are mainly due to $7.3 billion of redemptions among the open-end funds, as $2.5 billion of net unit creation among the high-yield ETFs has partially offset the open-end outflows.

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 www.morningstarcreditratings.com