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Credit Insights

Strong Investor Demand for Corporate Bonds Drives Credit Spreads Tighter

Strong investor demand, especially from overseas, drove corporate credit spreads tighter across the board last week. In the investment-grade market, the average spread of the Morningstar Corporate Bond Index tightened by 4 basis points to +111, its tightest level since October 2018. In the high-yield market, the ICE BofAML High Yield Master II Index tightened 18 basis points to +389.

Corporate bond markets have realized outsized gains this year as the combination of tightening credit spreads and declining interest rates have driven bonds prices higher. Thus far this year, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) has risen by 9.98%, and the ICE BofAML High Yield Master II Index has increased 10.70%. Year to date, credit spreads have tightened 46 basis points in the investment-grade market and 144 basis points in the high-yield market. However, while credit spreads have tightened significantly more in the high yield market, the return for investment-grade bonds has mostly kept pace with the high-yield market. The investment-grade bond index has a much longer duration than the high-yield index and the decline in underlying interest rates has driven a significant amount of its return. The deceleration in economic growth and resulting expectation by the market that the Federal Reserve will embark on a monetary easing program has driven interest rates lower across the yield curve. Year to date, the interest rates on 2-, 5-, 10-, and 30-year bonds have fallen by 63, 66, 61, and 42 basis points, respectively, to 1.86%, 1.85%, 2.07%, and 2.59%.

Economic growth slowed in the U.S. during the second quarter, as the annualized rate of GDP only rose 2.1% compared with the 3.1% annualized growth rate in the first quarter. However, this growth rate was much better than expected, as the consensus among Wall Street economists was 1.9% and the GDPNow model estimate from the Atlanta Federal Reserve Bank was 1.3%. Economic growth in the second quarter was bolstered by a 4.3% increase in personal consumption expenditures and a 5.0% increase in government spending. These increases were offset by a decline in gross private domestic investment of 5.5%, which was mainly driven by a 10.6% contraction in nonresidential structure.

Although many recently released economic metrics have been able to surpass the downbeat expectations, the market continues to price in an interest-rate cut this week as a foregone conclusion. According to the CME FedWatch Tool, the market is pricing in an 80% probability of a 25-basis-point cut to a range of 2.00% to 2.25% and a 20% probability of a 50-basis-point cut to a range of 1.75% to 2.00%. Expectations for a potential 50-basis-point cut had been higher a month ago, but the case for a 50-basis-point cut had been diminished by recently reported economic indicators such as the strong June retail sales and payroll reports.

If the Fed does lower the federal-funds rate next week, this will be the first interest-rate cut since the depths of the global financial crisis at the end of 2008. While the markets are pricing in a cut to the federal-funds rate following its Federal Open Market Committee meeting on July 30-31 as a foregone conclusion, this meeting is not scheduled to release an updated Summary of Economic Projections. The next release is scheduled to be in conjunction with the Sept. 17-18 meeting. The United States is not alone in its pivot toward easing monetary policy. The European Central Bank has also been signaling its intentions to further ease monetary policy in the European Union. The ECB is reportedly considering cutting its already negative short-term interest rate, instituting additional bond-buying programs, and/or providing enhanced guidance that the central bank could leave its short-term interest rate at a negative yield even longer.

Last week, we highlighted reports from Wall Street traders that international investors were actively searching for offers on U.S.-dollar-denominated corporate bonds. With approximately $13 trillion of debt in Europe trading at a negative yield, international investors are searching for positive returns wherever they can find it. Prices on German bonds continued to drift upward last week and pushed the yield even deeper into negative territory. The 5- and 10-year German bonds ended the week at their historically most negative yield of 0.67% and 0.38%, respectively. Even Spain’s 10-year bonds hit a record low interest rate of 0.37%. As another indication of how low interest rates are in Europe, Greek 10-year bonds traded below 2%. Even allowing for the fact that Greek bonds trade in euros and are traded as a spread over benchmark German bonds, it’s still astonishing that Greek bonds are trading at a lower yield than equivalent-maturity U.S. Treasury bonds. It was only eight years ago that Greece restructured its sovereign debt in which holders of those bonds took significant cuts.

European accounts were reportedly looking for longer-duration U.S. corporate bonds that were rated single-A and better and Japanese investors were searching for intermediate-duration bonds that were rated mid-BBB and higher. In the European corporate bond market, the new-issue market was busy as issuers look to lock in low all-in interest rates before the typical summer slowdown begins in August as many investors head to the beach for vacation. Compared with U.S. corporate bonds that still trade at a positive yield, several highly rated European issuers are reportedly eyeing the chance to issue euro-denominated bonds at a negative yield as the credit spread that their bonds trade over German benchmark bonds is tighter than the negative yield of the underlying bonds.

Weekly High-Yield Fund Flows

High-yield inflows continued their winning streak and posted their seventh consecutive weekly inflow last week. According to our data, this is the first time since October 2013 that inflows have registered seven consecutive weekly inflows. For the week ended July 24, high-yield inflows registered $1.3 billion. Inflows were almost entirely driven by $1.2 billion of net new unit creation across the high-yield exchange-traded funds, whereas the high-yield open-end mutual funds only realized inflows of $0.1 billion.

Year to date, inflows into the high-yield asset class total $18.1 billion, consisting of $12.2 billion worth of net unit creation among the high-yield ETFs and $5.9 billion of inflows across the high-yield open-end mutual funds.

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