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Quarter-End Insights

Credit Market Outlook: Tailwind From Declining Interest Rates Has Likely Run Its Course

The boost from declining rates may be over, but macroeconomic fundamentals in the U.S. should generally be supportive of credit risk.

David Sekera
  • A tailwind from declining interest rates was the main driver for corporate bond returns.
  • Battered energy bonds spill into the broader corporate bond market.
  • U.S. macroeconomic fundamentals aver for low credit risk, but global dangers abound.

Declining interest rates have bolstered fixed-income returns in 2014, but they have likely run their course and will not be a tailwind in 2015. Plunging oil prices have taken their toll on bonds in the energy sector, but macroeconomic fundamentals in the U.S. should generally be supportive of credit risk and will limit the amount credit spreads will widen in the near term. As such, with its lower duration and higher credit spread, the high-yield sector will likely outperform investment grade in 2015.

A tailwind From Declining Interest Rates Was the Main Driver for Corporate Bond Returns
Last quarter, we opined that the corporate bond market would struggle to generate much more than break-even returns for the remainder of the year. We noted that with the Fed concluding its asset purchase program, market liquidity in the bond market would decline and credit spreads were unlikely to tighten. In addition, we highlighted that corporate credit spreads were near their all-time tights on a rating-adjusted basis, yet the economic outlook called for only modest growth.

Since the end of last quarter, investment-grade credit spreads have widened 27 basis points on the back of plummeting oil prices. Quarter-to-date through Dec. 15, 2014, the Morningstar Corporate Bond Index has risen by 1.15%, driven almost entirely by the rally in Treasury bonds. High-yield bonds did not fare as well, and the Bank of America Merrill Lynch High Yield Master II Index has declined by 3.13% over the same time frame. While high-yield bonds had also benefited slightly from the rally in Treasuries, a substantial widening in high-yield credit spreads more than offset that tailwind.

For 2014, the corporate bond market has posted a much higher return than we had originally expected going into the year. Year to date, the Morningstar Corporate Bond Index has risen by 6.81%. In addition to realizing the yield carry in the underlying index, the excess return was completely driven by declining long-term interest rates as credit spreads in the U.S. have widened this year. As economic weakness spread through Europe and the emerging markets and plunging oil prices are reverberating throughout the asset markets, investors have sought refuge among the safety of U.S. Treasury bonds. This year, the yield on the 10-year Treasury has declined 93 basis points to 2.10%, its lowest yield since the market began to price in the tapering of the Fed's asset purchase program in May 2013. Since the end of last year, the average spread of the Morningstar Corporate Bond Index has widened 25 basis points to a spread of 145 over Treasuries.

High-yield bonds typically have shorter duration and are less correlated to movements in interest rates. As such, the high-yield sector has lagged the return of investment-grade bonds. Year to date, the Bank of America Merrill Lynch High Yield Master II Index has risen only 0.36%. The average credit spread in the index has widened 152 basis points to +552, which has almost completely offset the benefit of carry and lower interest rates.

Battered Energy Bonds Spill Into the Broader Corporate Bond Market
Oversupply in the oil market, coupled with weakening demand, has sent oil prices plummeting. According to the International Energy Agency, global oil supply currently sits at 94.2 million barrels per day, and demand trails by 1.8 million barrels at 92.4 million barrels per day. Since its recent peak on June 20, 2014, the spot price for West Texas Intermediate crude has fallen over $50 per barrel into the mid-$50 range. The decline began in June but accelerated (down more than 22%) after the market was surprised by OPEC's decision on Nov. 27 to maintain production at 30 million barrels per day. Most industry analysts were expecting the cartel to announce a roughly 500 thousand barrel per day decline in production.

By our estimates, oil markets are oversupplied by roughly 1 million barrels a day. Absent a conscious reduction in production, the amount of oversupply may increase into early 2015. In the short term, any further demand weakness could spark another leg down in oil markets before any recovery takes hold. However, over the medium term, we expect that lower crude prices will stimulate demand, thus reducing the current oversupply and supporting higher prices in the future. Despite the recent decline in prices, we have maintained a midcycle price forecast of $90 per barrel WTI. This price reflects the marginal cost of North American shale production. If prices become entrenched near the current level, the impact of producers slowing growth capital expenditures and the natural declining production curve of existing shale wells will prune North American production fairly quickly, helping restore the global supply-demand equilibrium and boost prices.

As oil prices have declined, credit spreads in the energy sector of the Morningstar Corporate Bond Index have widened substantially. As of June 20, the energy component of the index stood at 129 basis points over the nearest Treasury, relative to the index as a whole at +102 basis points. Since then, the energy component has widened 99 basis points, whereas the industrial segment of our index has widened only 36 basis points. If we strip out the energy constituents (11% of the index), the index would have widened only 28 basis points.

As seen in the chart below, the uplift in spreads caused by energy companies in the index has been increasing since early June (the uplift is currently 16 basis points). While the inaugural export of U.S. crude condensate on July 30 caused short-lived energy spread widening, spread differential growth accelerated on Nov. 27 with OPEC's announcement. The impact of lower oil prices has been disproportionately felt by lower-rated energy issuers. Among the higher-rated energy issuers in the index (A- and higher), credit spreads have widened only 39 basis points. The BBB rating bucket (composed of BBB+, BBB, and BBB- rated companies), where roughly half of the energy constituents live, has widened 160 basis points over the same period. Digging even deeper within this category, the majority of the companies that experienced the most significant widening fell into one of two sub-sectors: offshore drillers (such as  Transocean (RIG) and Noble ) and foreign national oil companies (such as  Petrobras (PBR) and Rosneft).

 

Within the energy sector, spreads of the various subsectors have differed in magnitude to declining oil prices. As can be seen in the chart below, the offshore drillers have widened the most, as the decline in oil prices has exacerbated an already weak operating environment. After the drillers, oilfield services has been the subsector with the most widening within the energy sector, followed by the exploration and production subsector, and finally the integrated subsector, which has shown the least widening in the face of the oil price decline.

U.S. Macroeconomic Fundamentals Aver for Low Credit Risk, but Global Dangers Abound
Macroeconomic fundamentals in the U.S. should be generally supportive of credit risk and keep domestic corporate credit spreads from rising too much further in 2015. Robert Johnson, our director of economic analysis, expects the momentum from strong GDP growth in the fourth quarter to carry over into 2015 and is forecasting GDP growth for 2015 between 2.0% and 2.5%. The combination of modest economic growth and low interest rates should keep default rates from rising meaningfully this year.

In our view, the greatest risk to bondholders will continue to be idiosyncratic risk leading to credit rating downgrades, as opposed to macroeconomic risk. However, global events that would precipitate a general widening in credit spreads include a recessionary environment in the euro area, which could presage sovereign debt and banking concerns; rapid deceleration of economic growth in China and the other emerging markets, which would pressure countries reliant on commodity exports; and financial dislocations stemming from Japan, as the yen has depreciated rapidly.

Whereas last quarter we thought credit spreads were generally fairly valued, albeit at the tight end of the range that we consider fairly valued, we now see credit spreads at the wide end of the range that we think is fair value. The current average credit spread of the Morningstar Corporate Bond Index is +145 basis points over Treasuries. This level is about 4 basis points tighter than the median level and 25 basis points tighter than the average level over the past 15 years.

We expect high-yield bonds to provide a better return than investment grade in 2015. The issuers most affected by falling oil prices have taken the brunt of losses over the past few weeks, and the additional carry in the index will help offset any further widening if oil prices fall more. In addition, while we don't foresee interest rates spiking higher, we do expect interest rates to drift upward through the year. High-yield bonds have a lower duration and will be less affected by rising rates. This factor, along with our forecast of moderate economic growth in the U.S., should hold down default rates, and it leads us to believe that high-yield bonds should hold their value better than investment-grade bonds.

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