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Credit Insights

Interest Rates Spike, but Credit Spreads Contract as Investors Find Value in Corporate Bonds

Strategic M&A heats up while large LBOs remain cool.

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After hitting their lowest levels since May 2013 the prior week, interest rates rose at the beginning of last week and then spiked higher Friday after a relatively strong payroll report. Nonfarm payrolls increased by 257,000, well ahead of the consensus estimate. The yield on the 10-year U.S. Treasury bond rose 26 basis points over the course of the week to end Friday at 1.94%. Although underlying interest rates rose, tightening corporate credit spreads were able to offset some of the principal loss. The average spread of the Morningstar Corporate Bond Index tightened 7 basis points to +148 and the average spread of the Bank of America Merrill Lynch High Yield Index tightened 48 basis points to +478. Year to date, the Morningstar Corporate Bond Index has risen 1.55% compared with the 1.11% increase in the Morningstar US Government Bond Index.

In addition to the strong employment report, China fueled the "risk on" sentiment last week after it announced it is cutting its reserve requirement ratio. The reserve requirement ratio determines the amount of capital that Chinese banks must hold against loans. Decreasing the ratio frees up capital that the banks can use to make additional loans. The intent is that these additional loans will help stimulate the Chinese economy, which has been slowing. Two weeks ago, we highlighted that while Chinese GDP had increased 7.3% in the fourth quarter, we expect its growth rate will slow substantially. A significant amount of the growth in China's economy has been driven by a boom in real estate. However, real estate prices have stagnated or declined and demand has faltered, leading to declining new construction starts and slowing real estate sales. With faltering starts and sales, floor space under construction growth is likely to weaken in the next several quarters. With it, so will real estate fixed-asset investment and GDP.

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