Skip to Content
Quarter-End Insights

Credit Markets: Investment Grade Struggles, While High Yield Outperforms

Interest rates appear poised to rise further over time as the economy improves, creating an environment in which high yield should continue outperforming investment-grade.

  • Rising rates reduce returns.
  • Corporate credit spreads: investment-grade struggles, while high-yield outperforms.
  • Slow but steady economic growth will support the corporate credit market.
  • Long-term interest rates begin to normalize toward historical norms.

Rising interest rates have led to slight losses in many fixed-income indexes as lower bond prices offset the yield carry. Interest rates appear poised to rise further over time as they normalize relative to other financial metrics and an improving economy. In such an environment, we expect high yield to continue outperforming investment-grade.

Rising Rates Reduce Returns
Last quarter, we discussed how speculators had bid up the prices of bonds so high in many European countries that the effective yields on sovereign bonds were negative if held to maturity. Essentially, that meant investors were locking in guaranteed losses if they held the bonds until maturity. In our opinion, that would only make economic sense for one of two reasons.

One, if an investor were expecting a significant global deflationary event that would decimate other asset values across the world; or two, if an investor intends to sell the bonds to another investor at a price that locks in an even greater loss/negative yield. In this case, speculators bid up bond prices in anticipation of flipping the bonds to the European Central Bank for a profit. The ECB began its quantitative easing program during the first quarter and had stated that it would buy debt under its asset purchase program, even if it were trading at a negative yield. As these sovereign bond yields dropped, interest rates declined across all of the developed markets as global investors searched for yield anywhere they could find it.

This strategy has not worked out for many speculators as interest rates in the United States bottomed out during late January and hit their lowest levels in Europe during April. Since then, interest rates have steadily risen. For example, as of June 24, the yield on the 10-year U.S. Treasury has risen to 2.38%, 21 basis points higher than at the end of last year and 71 basis points off the January lows. In Europe, the German 10-year Bund has risen to 0.84%, 30 basis points higher than at the end of last year and 77 basis points off its April low.

As underlying rates have risen, bond prices have been pushed down to where most domestic fixed-income indexes are either barely positive or have declined year to date. While domestic and European fixed-income indexes have struggled, emerging-market indexes have performed well.

Declining bond prices have offset the amount of interest that income bonds have generated in the short term, and it appears this trend may continue over the second half of the year. Interest rates may rise further toward normalized levels as the Fed appears poised to raise the federal-funds rate later this year. In our view, with the economy looking stronger in the second quarter, the yield on the 10-year Treasury bond could easily rise to 3.0%-3.5% to reach a more normalized level relative to inflation, inflation expectations, and the shape of the yield curve.

Corporate Credit Spreads: Investment Grade Struggles, While High Yield Outperforms
Thus far this year, investment-grade corporate credit spreads have languished, whereas, high-yield spreads have performed well. Since the end of last year, the average spread in the Morningstar Corporate Bond Index (our proxy for investment-grade bonds) has widened 8 basis points to +148. However, the credit spread of the Bank of America High Yield Master II Index has tightened 38 basis points to +466.

In our first-quarter outlook published late last year, we made the case for the high-yield market outperforming investment grade in 2015. Although much of the outperformance we expected in high yield for this year has already occurred, we continue to believe that high-yield bonds will provide a better return than investment grade. High-yield bonds have a much lower correlation to underlying interest rates than investment-grade bonds do and are more dependent on economic conditions. Even though the contraction in GDP for the first quarter was disappointing, Robert Johnson, CFA, Morningstar's director of economic analysis, projects full-year 2015 GDP growth to range between 2.0% and 2.5%. As such, GDP growth will have to average over 3% for the remainder of the year to reach Johnson's forecast. This level of growth should be enough to hold down default rates, which will in turn support the high-yield market.

Last March, we cited that much of the recent demand in the U.S. corporate bond market had been attributed to foreign investors in developed markets looking to both pick up the higher all-in yields U.S. corporate bonds offer, as well as invest in the safety of the strengthening dollar. While the spread between the 10-year U.S. Treasury and 10-year German Bund has recently dropped to 154 basis points, it's not that far from its historically widest levels when the spread reached 185 basis points earlier this spring. In addition, the Bank of Japan continues to weaken the yen with its own asset purchase plan, which has prompted some Japanese fixed-income investors to also reallocate their asset mix into the U.S. corporate bond market.

With U.S. interest rates higher than European rates, the differential in yield between the Morningstar Corporate Bond Index and the Morningstar Eurobond Corporate Index is substantial. Currently, the average yield of our U.S. corporate bond index is 3.31%, compared with our European corporate bond index at 1.23%. In addition to the higher yield, the purchasing power of assets invested in U.S. dollar-denominated bonds has greatly appreciated. As the Federal Reserve has completed its quantitative easing program and is poised to begin raising interest rates later this year, the U.S. dollar has appreciated significantly. Year to date, the U.S. dollar has appreciated over 7% versus the euro and over the past year has appreciated by 17%. Comparatively, the U.S. dollar has appreciated 3% compared with the Japanese yen thus far this year and has gained about 21% since this time last year. Among those global fixed-income investors that can purchase debt denominated across multiple currencies, the higher all-in yields and the rising value of the U.S. dollar have driven up demand for U.S. corporate bonds.

Slow but Steady Economic Growth Will Support Corporate Credit Market
As previously highlighted, we expect real GDP growth for calendar 2015 will range between 2.0% and 2.5%. The contraction in economy in the first quarter should prove to be an anomaly as the temporary factors (such as the West Coast port strike and abnormal winter weather patterns) wear off and economic activity returns to normal. In addition, the decline in oil prices from last year should provide a tailwind for consumer spending by the second half of the year to help spur further economic growth. Historically, there has been a three to nine month lag effect between the decline in oil prices and resultant increase in consumer spending.

Recent economic metrics indicate that the economy is back on course. For example, in May, retail sales rose a solid 1.2% over April. Even excluding the increase from rising auto and gasoline sales, retail sales still rose 0.7%. In addition, both March and April sales reports were revised higher. This will in turn support GDP growth estimates for the second quarter. On a year-over-year basis excluding autos and gasoline, noninflation adjusted sales rose approximately 4%. This rate of growth is within the same slow and steady growth range that sales have expanded on a year-over-year basis over the past year.

In such a benign environment, corporate credit spreads appear fairly valued. Currently, the average spread of the Morningstar Corporate Bond Index is a half-standard deviation tighter than its historical average. In our view, the greatest risk to bondholders in general will continue to be steadily rising interest rates and for corporate bondholders, idiosyncratic risk leading to credit rating downgrades. While we don't expect long-term interest rates will spike higher in the short term, we continue to think that as monetary policy begins to tighten later this year, interest rates will rise as they normalize compared with inflation, inflation expectations, and the shape of the yield curve.

With their shorter duration, high-yield bonds are less correlated to movements in interest rates and returns are much more closely tied to economic growth. As such, we expect high-yield bonds to continue outperforming investment-grade bonds for the remainder of the year. However, global events that would precipitate a general widening in credit spreads include a rapid decline in oil prices, a recessionary environment in the eurozone (which could presage sovereign debt and banking concerns), or rapid deceleration of economic growth in China and the other emerging markets, which would pressure countries reliant on commodity exports.

Long-Term Interest Rates Begin to Normalize Toward Historical Norms
Last quarter, we opined that interest rates should continue to rise as they migrate back toward historical norms as compared with inflation, inflation expectations, and the shape of the yield curve. In addition, while the decline in first-quarter GDP was disappointing, recent economic indicators are pointing to a much stronger second quarter.

Inflation does not appear to be a near-term concern but could begin to emerge as soon as next year as the impact of falling oil prices fades in the second half of this year, lapping the beginning of the decline last summer. While the headline reading for the Consumer Price Index for April was a moderate 0.1%, CPI excluding food and energy rose more than expected. CPI less food and energy rose 0.3% month over month and 1.8% year over year. Although the Fed's preferred measure of inflation may be the Personal Consumption Expenditure Index, the core CPI reading remains close to the Fed's targeted inflation rate of 2%. The higher reading was driven by a 0.7% month-over-month increase in the medical care index as well as a 0.6% increase in used vehicles and a 0.5% increase in household furnishings. Low oil prices have helped keep overall inflation levels low since last fall, but with oil prices stabilizing, the downward pressure on inflation will start to abate in the second half of the year. Based on Morningstar director of economic analysis Johnson's calculations, if core inflation remains at 1.8% and gasoline prices stay where they are now (30% off their recent lows), the total inflation rate could rise to 2.2% in December and 3% in January and February 2016.

As such, we think it is becoming increasingly difficult for the Fed to justify keeping short-term rates at zero percent. The original intent for the zero interest rate policy was as an emergency measure to support the entire financial system in December 2008, when then economy was in a free-fall, and that this policy would only be kept in place during the financial crisis and would normalize soon thereafter. With declining unemployment and modestly positive economic growth, we expect this backdrop will be sufficient to encourage the Fed to begin raising short-term rates in the second half of 2015. As short-term rates adjust upward to incorporate the rising Fed funds rates, we think the normalized interest rate for the 10-year Treasury is between 3.00% and 3.50%.

However, we also recognize that several exogenous factors are playing a role in making U.S. Treasury bonds increasingly attractive to foreign investors. The outlook for European growth remains moribund while sovereign interest rates in the eurozone have fallen. In fact, with the yield of German 10-year bonds under 1% and Japanese bonds only yielding a half a percent, for foreign investors, U.S. Treasuries are providing both a pickup in yield as well as offering relative safety from further depreciation in foreign exchange rates, as many global central banks attempt to weaken their own currencies relative to the U.S. dollar.

Correction: An original version of this article misstated the June 24 yield on the 10-year Treasury. The correct yield as of that date was 2.38%. 

More Quarter-End Insights