Credit Insights

Rising Oil Prices Support Modest Rally in Corporate Bond Market

Dave Sekera, CFA

After investment-grade corporate credit spreads hit their widest levels of the year two weeks ago, the corporate bond market exhibited a modest rally last week and tightened 3 basis points to +113. In the high-yield market, the average spread of the BofA Merrill Lynch High Yield Master Index tightened 9 basis points, but at +340 basis points, it remains near its average this year. While corporate bonds only eked out a modest rally, the S&P 500 rose 2.41% last week, bringing that index into positive territory for the year. Oil rose to over $70 per barrel early in the week and held above $70 for the first time since November 2014. At that point, instead of riding an uptrend as it is now, the price of oil was plummeting from its highs of over $100. Several weeks ago, Andy O'Conor, the Morningstar Credit Ratings analyst who covers the energy sector, noted that officials in Saudi Arabia had begun to hint to the markets that they would be comfortable with oil closer to $80 per barrel. Since then, oil has risen from the low to mid-$60s and appears positioned to move higher as we swing into the summer driving season. Higher oil prices have bolstered corporate bonds in the energy sector, especially among the lower-rated issuers. In the investment-grade index, the average credit spread of the energy sector tightened 4 basis points last week; in the high-yield index, the energy sector tightened 20 basis points.

The trend in the Treasury market remained the same: Short- and medium-term interest rates continued to rise, while the yield at the longest end of the curve declined. At the shorter end of the yield curve, the yield on the 2-year Treasury bond rose 3 basis points to 2.53%; in the belly of the curve, the yield on the 5-year Treasury bond rose 6 basis points to 2.84%. The yield on the 10-year rose and continued to flirt with 3% but was unable to break through that psychological hurdle, ending the week 2 basis points higher at 2.97%. At the longest end of the curve, the yield on the 30-year bond declined 2 basis points to 3.10%. Since the end of the year, interest rates have risen significantly as the 2-year, 5-year, 10-year, and 30-year bonds have risen 65, 63, 56, and 36 basis points, respectively.

The yield curve has been on a multiyear flattening trend since the Federal Reserve began to raise short-term rates in its pursuit to normalize monetary policy. As short-term rates have risen faster than long-term rates, the steepness of the yield curve has flattened to its lowest level since before the 2008-09 credit crisis. In the past, when the yield curve has been flattening, it has often been an indicator of a weakening economy and in many cases portended a recession. This time around, this signal may not be foreshadowing a recession, as it is being heavily influenced by global central bank actions, and current economic activity hasn't shown any indications of slowing. In fact, as an indication of the current economic strength, the Atlanta Fed's GDPNow model forecast for second-quarter real GDP growth is 4.0%, which would be a strong acceleration from the 2.3% rate in the first quarter. In fact, 4.0% would be the strongest quarterly growth rate since the third quarter of 2014.

At the short end of the curve, interest rates have been rising in connection with the hikes that the Fed has conducted this year, with the market pricing in additional rate hikes before year-end. The next Federal Open Market Committee meeting will be June 12-13; following the meeting, the Fed is scheduled to release its next Summary of Economic Projections and conduct a press conference. According to the CME FedWatch Tool, the market is pricing in a rate hike with certainty following this meeting. In addition, the futures market is pricing in further rate hikes by year-end. The probability that the federal-funds rate will end the year at 200 basis points or higher is 90%, and the probability that it will end the year at 225 basis points or higher is 47%.

While the Fed's monetary policy actions have been directly affecting short-term rates, the long end of the curve may be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. Even though the 10-year U.S. Treasury is yielding only 2.97%, that is attractive to global bond investors as the yield on Germany's 10-year bond is 0.56%, and the yield on Japan's 10-year bond is barely positive at 0.05%. The ECB will continue its quantitative easing program through the summer and early fall, planning to purchase EUR 30 billion per month until September. It is unlikely that the ECB will conduct any monetary tightening actions until well into next year.

High-Yield Fund Flows: In One Week, Out the Next
The seesaw between inflows and outflows in the high-yield asset class continued last week as a net $0.9 billion was pulled out of high-yield open-end mutual funds and exchange-traded funds. Year to date through May 9, there has been a total of $12.2 billion of outflows across the high-yield sector: $7.6 billion of outflows in open-end high-yield mutual funds and $4.6 billion of net unit redemptions in high-yield ETFs.

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