With interest rates poised to rise further and credit spreads near their tightest levels since the end of the 2008–09 credit crisis, we expect rising rates to largely offset the yield that investment-grade corporate bonds currently offer.
Rising Rates and Tight Credit Spreads Will Constrain Corporate Bond Returns
In our last quarterly outlook, we suggested that low interest rates and tight credit spreads would constrain returns in the corporate bond market. For the third quarter through Sept. 15, the Morningstar Corporate Bond Index has declined 0.26%, and in the high-yield sector, the Bank of America Merrill Lynch High Yield Master II Index has declined by 0.95%. In the third quarter, the average spread of the Morningstar Corporate Bond Index, our proxy for investment-grade, has widened by 6 basis points to +112. In the high-yield sector, credit spreads have widened 53 basis points to +406 during the third quarter, offsetting much of the tightening from earlier this year.
However, year to date through Sept. 15, both asset classes have generated respectable returns. The Morningstar Corporate Bond Index has risen 5.39% as interest rates remain lower than at the start of the year and investment-grade credit spreads have tightened 10 basis points. The high-yield index has risen 4.63% because of lower interest rates and higher yield carry, partially offset by widening credit spreads, which rose 6 basis points.
For the fourth quarter, we think corporate bonds in general will struggle to generate much more than break-even returns. With the Fed exiting its asset purchase program, we think interest rates will rise toward more normalized levels compared with inflation, inflation expectations, and the shape of the yield curve. With interest rates poised to rise further and credit spreads near their tightest levels since the end of the 2008–09 credit crisis, we expect rising rates to largely offset the yield that investment-grade corporate bonds currently offer.
We expect high-yield will provide a better return than investment-grade as the high-yield segment has a much lower correlation to underlying interest rates. Returns for investment-grade bonds are more closely correlated to underlying interest rates and have substantially less excess credit spread to offset rising yields. This factor--along with our forecast of moderate economic growth in the U.S. (on average at a 3.4% rate for the third and fourth quarters), which will hold down default rates--leads us to believe that high-yield bonds should hold their value better than investment-grade bonds.
On a Ratings-Adjusted Basis, Investment-Grade Credit Spreads Are Near Historical Lows
We think credit spreads are generally fairly valued, albeit at the tight end of the range that we consider fairly valued. The current average credit spread of the Morningstar Corporate Bond Index is +112 basis points over Treasuries, which is about 40 basis points tighter than the median and 60 basis points tighter than the average over the past 15 years. Even after stripping out the impact of the 2008-09 credit crisis, the current level is still very tight compared with historical averages.
The tightest level the index has registered was 20 basis points tighter at +80 basis points in February 2007. While this data point might suggest there is more room for the index to run, on a ratings-adjusted basis, this is not the case. The average rating of the index is a notch lower now than it was then. The average rating of the index is currently A-, whereas in February 2007, the average rating was A. Considering that the spread differential in the market between A and A- bonds is currently 16 basis points, on a ratings-adjusted basis, it appears that there is much less room for credit spreads to tighten before they return to their historically tightest levels.
While volatility in credit spreads has not yet reached its historically lowest levels, similar to credit spreads, it has been steadily declining since the beginning of the year. In the following chart, we measure the standard deviation of the difference between the daily spread of the Morningstar Corporate Bond Index and the average historical spread on a trailing six-month basis. Currently, the standard deviation is 4 basis points. The lowest standard deviation was 2 basis points, reached in November 2006, and the long-term historical average is 19 basis points. As credit spreads remain in a tight trading range, we expect the standard deviation will continue to decrease and enter a period similar to 2006 in which the variability of credit spreads remained unusually low for several years. By examining the 2006-07 time frame, it appears that prolonged periods of low volatility can leave credit spreads unusually low for several years until a catalyst causes investors to re-evaluate their risk tolerances.
As credit spreads have compressed, investors have been stretching further into lower-rated fixed-income securities to reach for yield. As such, the spread between corporate bonds with different ratings has been compressing. For example, the differential between the average single-A and BBB spread to Treasury in our Corporate Bond Index has declined to +58 basis points from +82 basis points a year ago and compared with the 15-year average spread differential between the ratings of +70 basis points.
Across our coverage, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names will probably be offset by an increase in idiosyncratic risk (debt-funded mergers or acquisitions, increased shareholder activism, etc.). However, considering that spreads are already at the tight end of where we think fair value lies and liquidity in the market is low, we caution that there is risk in the near term given the negative catalyst that credit spreads could quickly widen.
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