A Divergent Fourth-Quarter for Bonds

David Sekera: The corporate-bond market struggled in the third quarter. For example, in the investment-grade sector, our index--the Morningstar Corporate Bond Index--registered a 7 basis point loss for the quarter. This was mainly drive by widening credit spreads. So, for example, the average spread in our index widened out 13 basis points to 118 basis points over Treasuries at the end of the quarter, which is actually in line with about where credit spreads were at the beginning of this year. We also saw some losses in the shorter portion of our index. So, for example, interest rates in the two- to five-year part of the curve had widened out while the 10- and 30-year part of the Treasury curve remained relatively stable.

While the return in the investment-grade space was relatively unchanged for the quarter, the high-yield sector suffered much worse returns. For example, the average return in the [BofA Merrill Lynch US High Yield Master II Index] was actually down 1.9% last quarter, and that was due also to credit-spread widening. For example, the average spread within their index had actually widened out about 90 basis points and ended the quarter at 440 basis points.

Going forward, in the fourth quarter, we expect corporate-bond markets will also continue to struggle again. So, for example, in the investment-grade space, we expect underlying interest rates will rise as the [Federal Reserve] exits its asset-purchase program. And as we see the economy or at least our expectation that the economy will continue to grow at a moderate pace, interest rates will rise toward more historically normalized rates.

Having said all that, the high-yield bond universe is not as correlated to interest rates as the investment-grade bond universe. We actually think that high-yield bonds should hold their value better over the course of the fourth quarter. So, expecting moderate economic growth, that should help keep default rates low. And as default rates are low, we can see some of the spread widening that occurred in the third quarter reverse and start to tighten back up in the fourth quarter.