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Credit Insights

Higher Yields Fail to Attract Buyers

Interest rates have begun to rise as the market is pricing in an increasing probability that the Fed may begin to taper off its asset-purchase program within the next few months.

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Corporate credit spreads began to widen out Thursday morning, accelerated higher in the afternoon, and continued to widen all day Friday. Wall Street traders were long and wrong and had a difficult time finding buyers, even though all-in yields were much higher due to the rise in interest rates. The 10-year Treasury bond widened 15 basis points, ending the week at 2.16%, its highest level since April 2012. Since the beginning of the year, the 10-year has widened a total of 40 basis points. Traders complained that the price action in the corporate bond market felt extremely poor, as buyers were too timid to bid for bonds as interest rates rose rapidly. Investors who did venture into the waters to buy bonds were immediately offered more and oftentimes at lower prices, forcing them to mark down the bonds they just bought. Even though the S&P fell 1.5% last week, it still has a 14.3% gain for the year, whereas the average spread in the Morningstar Corporate Bond Index widened 4 basis points to +137, which takes us to the same level as we began the year. Morningstar's European Corporate Bond index widened 2 basis points to +116, which is 24 basis points tighter for the year.

Interest rates have begun to rise as the market is pricing in an increasing probability that the Fed may begin to taper off its asset-purchase program within the next few months. We have cautioned investors numerous times that once the Fed announces its intention to begin tapering, interest rates will probably rise 100-150 basis points in a relatively short time. In last week's Bond Strategist, we included a chart illustrating that the yield on 10-year Treasury bonds has historically averaged about 200 basis points over inflation. Even at the currently low rate of inflation of about 1%, the 10-year rate should increase another 100 basis points to return to historical averages. However, as Treasury rates begin to meaningfully surpass the dividend yield of the S&P 500, we expect the pace of rising interest rates will slow as the higher rates attract new investors, especially those who had been allocating assets into high-dividend-paying stocks as a substitute for fixed-income investments.

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David Sekera does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.