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Credit Insights

Strong New Corporate Bond Issuance Satiates Most Investor Demand

Even though there has not been any progress toward a resolution of the trade disputes with China and two oil cargo ships were attacked near the Strait of Hormuz, investors were willing to bid up the price of risk assets. In the corporate bond market, there was a healthy amount of new issues priced as corporations looked to take advantage of the combination of the lowest interest rates in years and strong demand for corporate bonds. As an example, according to Commercial Mortgage Alert, there were $5.4 billion of new issues priced from issuers in the REIT sector, a new weekly dollar volume record. Chris Wimmer, Morningstar Credit Ratings’ vice president covering REITs, noted that “These companies either have a need for term financing sooner rather than later, or they have been active in investing and maybe development, have been putting it on their revolvers, and decided that because of the good execution they are getting today, now was the more certain time.”

Even though new supply helped satiate a significant amount of the investor demand, corporate credit spreads tightened across the markets. The average credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) tightened 1 basis point to +130 and in the high-yield market, the ICE BofAML High Yield Master II Index tightened 14 basis points to +423. In the equity market, the S&P 500 rose 0.47% and is currently only 2% lower than its all-time closing high.

  - Source: Morningstar, Inc., ICE BofAML Global Indexes. Data as of 06/14/2019

Trading and volatility in the Treasury bond market were relatively muted as government bond portfolio managers stepped to the sidelines while they await the outcome of this week’s Federal Open Market Committee meeting on Tuesday and Wednesday. The yield curve steepened slightly over the course of the week. In the short end of the curve, yields on the 2- and 5-year Treasury declined 1 to 2 basis points, whereas in the longer end of the curve, 10- and 30-year bonds were flat to 2 basis points higher. After bottoming out at 11 basis points, the spreads between 2- and 10-year Treasury bonds have been trending upwards and has increased to 26 basis points.

While Fed officials have intimated to the markets that they have been leaning toward easing monetary policy, according to the CME FedWatch Tool the markets are only pricing in a 23% probability that the Fed will cut the federal-funds rate this week. However, that probability steps up quickly over the remainder of this year. Following the September meeting (in which the FOMC will release its updated Summary of Economic Projections) the probability that the federal-funds rate will remain unchanged at its current level is only 3% and probabilities that the federal-funds rate will drop to the following ranges are:

  • 2.00% to 2.25% is 27%
  • 1.75% to 2.00% is 55%
  • 1.50% to 1.75% is 14%.

Yet, while the markets may be convinced that the Fed will begin to ease monetary policy, based on recent economic metrics, economic growth in the second quarter may not have slowed as much as suspected. For example, May retail sales grew by 0.5% month over month, and the April sales report was revised higher by 0.5%. Based on these levels, consumption growth is projected to increase by 4% on an annualized basis in the second quarter. Following the retail sales report, the Atlanta Federal Reserve Bank’s GDPNow model estimate for the seasonally adjusted annual rate of real GDP growth in the second quarter of 2019 spiked to 2.1% from the prior reading of only 1.4%. The current reading is the highest it’s been this quarter, as the reading had previously topped out at 1.7% in the beginning of May.

Economic growth continues to be supported by financial conditions in the U.S., which remain highly accommodative. The Federal Reserve Bank of Chicago publishes a weekly index that measures more than 105 variables to gauge how “loose” or “tight” financial conditions are among U.S. capital markets, as well as the traditional and shadow banking systems. These variables include credit availability and cost, leverage, risk, interest rates, and credit spreads. Index levels above zero indicate tighter than average conditions, whereas levels below zero represent looser than average conditions. The National Financial Conditions Index is currently indicating that financial conditions are at their loosest since October 1994.

In Europe, negative interest rates continue to rule the markets. The yields on Germany’s 5- and 10-year bonds were unchanged at negative yields of 0.60% (only 2 basis points from its prior record low) and negative 0.26% (the record low).

Year to date, fixed income indexes have produced outsized gains compared with the amount of yield carry that bonds would have generated alone. For example, the Morningstar Core Bond Index (our broadest measure of the overall fixed income market) has risen by 5.16%. A significant portion of this return can be attributed to the increase in bond prices as interest rates have fallen across the yield curve. Since the end of last year, the yields on the 2-year and 10-year Treasury bonds have fallen by 65 and 60 basis points, respectively. In the corporate bond market, indexes have been further bolstered by tightening corporate credit spreads. For example, even after spreads had widened in May, year to date the average spread of the Morningstar Corporate Bond Index has tightened 26 basis points and the ICE BofAML High Yield Master II Index has tightened 96 basis points. Thus far this year, our investment-grade corporate bond index has risen 7.85%, and the ICE BofAML High Yield has increased 8.96%.

Weekly High-Yield Fund Flows
Following on the heels of significant withdrawals the last few weeks, investors reversed course and piled back into the high-yield asset class. Inflows into high-yield assets totaled $1.6 billion, which was the fourth-largest weekly inflow thus far this year and the sixth-largest weekly inflow over the past 52 weeks. The inflows were predominantly concentrated among the high-yield exchange-traded funds, which registered $1.4 billion of net unit creation, whereas inflows among the high-yield open-end mutual funds was on $0.2 billion.

Year to date, inflows into the high-yield asset class totaled $10.8 billion, consisting of $7.4 billion worth of net unit creation among the high-yield ETFs and $3.4 billion of inflows across the high-yield open-end mutual funds. Including the outflows registered late last year, over the past 52 weeks, total outflows equal $5.7 billion, of which the redemptions were driven by $7.2 billion of withdrawals across the open-end mutual funds, which were partially offset by $1.5 billion of net unit creation among the high-yield ETFs.

  - Source: Morningstar, Inc. and ICE BofAML Global Indexes.

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