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Credit Insights

2Q Fixed-Income Index Overview

Falling interest rates drive further gains.

Bond prices rose during the second quarter, spurred by the decline in interest rates across the entire yield curve. The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose 2.92% in the second quarter. Underlying the Core Bond Index, the Short-Term Core Bond Index increased 1.67%, the Intermediate Core Bond Index rose 2.21%, and the Long-Term Core Bond Index surged 5.64% this past quarter. In the Treasury market, the Morningstar U.S. Government Bond Index increased 2.92%, and in the agency market, the Morningstar Agency Bond Index rose 2.52%. Even though inflation expectations dwindled over the past three months, the Morningstar TIPS Index gained 2.81%.

The outsize gains in these indexes compared with the underlying yield carry were driven by the decline in interest rates across the entire yield curve. After hitting its highest yield since mid-2008 last November, the interest rate on the 2-year Treasury bond has been steadily declining. As contagion from slowing global economic growth seeps into the U.S. economy and global central banks are shifting their stance toward easy monetary policies, the market has priced in multiple cuts to the federal-funds rate this year, beginning at the July meeting of the Federal Open Market Committee. As recently as mid-December 2018, the market had priced in at least one more rate hike in 2019. Now investors expect the Federal Reserve to cut the fed-funds rate this summer and then two more times before the end of the year. This change in expectations drove demand for U.S. Treasury bonds, especially in the short end of the curve. Since the end of March, the yields on the 2-, 5-, 10-, and 30-year Treasury bonds have declined 51, 46, 40, and 28 basis points respectively, to 1.75%, 1.77%, 2.01%, and 2.53%.

Even though many European sovereign bonds were already trading at negative yields at the beginning of the second quarter, the Morningstar Eurozone Bond Index was able to generate a return of 4.93%. The return was driven by the decline in underlying interest rates of benchmark German bonds into even greater negative yields. For example, the yield on Germany's 5-year bond declined 21 basis points and ended the quarter at a negative yield of 0.66%, while the yield on Germany's benchmark 10-year bond declined 26 basis points, ending the quarter at a negative yield of 0.33%. At these levels, the 5- and 10-years are trading at their most negative yield ever.

Among the benchmark sovereign bonds, U.S. Treasuries are comparatively some of the highest-yielding options. For example, the Swiss 10-year bond is trading at a negative yield of 0.53% and Japanese 10-year bonds are at a negative 0.16%. Currently, there is reportedly almost $12 trillion worth of global debt trading at a negative yield. When a bond is trading at a negative yield, an investor who holds the bond to maturity is guaranteed to lock in a loss. The only way an investor can earn a positive return is to sell the bond 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 4.21% in the second quarter. In the high-yield market, the ICE BofAML High Yield Master Index rose only 2.58%. The main reason for the difference in the returns is that the investment-grade index has a much longer duration than the high-yield index and was more positively affected by the decline in interest rates. In addition, the average spread in the investment-grade market tightened 3 basis points to +119, but in the high-yield market, the average credit spread widened 8 basis points to +407. In Europe, with interest rates at already negligible levels, the gains were muted as the Morningstar Eurobond Corporate Index rose only 3.11%.

Prices generally rose across all financial markets, all asset classes, and all over the world last quarter with only a few exceptions. Price action was mainly driven by global central banks' shift toward easy monetary policies. The rally began after European Central Bank President Mario Draghi recently said that the ECB was considering instituting new stimulus programs in July. These programs could include a cut in the ECB's already negative short-term interest rate, additional bond-buying programs, and/or additional forward guidance that the central bank could leave its short-term interest rate at a negative yield even longer. The rally then picked up steam after the June meeting of the Federal Reserve, which intimated to the markets that it too was shifting toward an easy monetary policy.

According to the CME FedWatch Tool, a rate cut is all but assured following the FOMC's July meeting. Currently there is a 74% market-implied probability of a 25-basis-point rate cut and a 26% chance of a 50-basis-point cut. Even after a rate cut in July, the market expects additional rate cuts before the year is over. Following the December meeting, the market-implied probabilities that the fed-funds rate will fall from its current range of 2.25%-2.50% to the following ranges are:

  • 10% for 2.00%-2.25%
  • 34% for 1.75%-2.00%
  • 37% for 1.50%-1.75%
  • 19% for below 1.50%

In the equity markets, the S&P 500 rose 3.79% last quarter and has risen 17.35% year to date. In Europe, where economic growth has been flagging, the equity market gains were magnified by the ECB's shift to ease monetary policy. For example, Germany's DAX rose 7.57% and the French CAC increased 3.52% during the second quarter. Thus far this year, these two indexes have gained 17.42% and 17.09%, respectively. Slowing economic growth weighed on the Shanghai Composite Index, which fell 3.62% this past quarter, but even including that pullback, the index is up 19.45% year to date.

Weekly High-Yield Fund Flows
Even though we wrote last week that we suspected high-yield fund inflows would pick up, we were surprised by the volume of inflows. For the week ended June 26, high-yield inflows surged $3.1 billion, the third-highest weekly inflow over the past 52 weeks. Inflows were weighted toward exchange-traded funds as net unit creation among high-yield ETFs rose $1.9 billion. High-yield open-end mutual funds realized inflows of $1.2 billion. Considering the market action in the latter half of last week and positive momentum in trade negotiations, we expect that high-yield fund inflows will continue over the first half of this week. Year to date, inflows to the high-yield asset class total $14.4 billion, consisting of $9.7 billion of net unit creation among high-yield ETFs and $4.7 billion of inflows across high-yield open-end mutual funds.

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