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Credit Insights

Equities Decline Following Months of Credit Market Weakness

Seasonal slowdown reduces new issue volume.

Corporate credit spreads widened further last week as a risk-off sentiment pervaded across the markets. The average spread of the Morningstar Corporate Bond Index widened 5 basis points to +174 and the average spread of the Bank of America Merrill Lynch High Yield Master Index widened 20 basis points to +586. These are the widest levels both of these indexes have traded at since 2012, when the markets were recovering from the Greek debt crisis and related European bank solvency concerns. There did not appear to be any single factor that instigated this recent bout of weakness, but rather a confluence of many factors. Investors are continuing to evaluate the impact of China's devaluation of the yuan, commodity prices weakened to multiyear lows, earnings from global industrial firms were lower than expected, and economic metrics indicate that the Chinese economy is softening at an accelerating rate.

Corporate credit spreads and stock prices measure two different yet related concepts. Corporate credit spreads are a measure of future probability of default and recovery value; stock prices are a result of the market's present-value estimate of future cash flows to equityholders. As a company's free cash flow generation grows, it typically reduces probability of default and, as a result, credit spreads will tighten. The free cash flow in excess of what is needed to satisfy debt and debtlike commitments is then attributed to the equityholders and drives stock prices higher. Even accounting for this difference, it appears that there has been a disconnect between these two markets over the past few months.

The S&P 500 has declined 4.3% this year, with the preponderance of the decline occurring last week, while the credit markets have been steadily softening over the past few months. Even after the sharp sell-off Friday, the equity index level is still more than 500 points higher now than in 2012, when credit spreads were last at these wide levels. Depending on whether the global economy strengthens and commodity prices like oil recover, or the global economy has hit a rut and commodity prices stay low, it is reasonable to expect that either credit spreads will improve as default risk abates, or equity prices may have further to fall if earnings are on the precipice of a downturn.

As one would expect during the typical seasonal slowdown in August, when many traders and portfolio managers take vacation time, trading volume in the secondary market was lower than usual. With many investors on the sidelines, the trading action in the secondary market was what many traders call gappy: In many instances after bonds traded, the next trade was conducted at a spread significantly wider (that is, gapped wider) than where the prior trade printed. This is indicative of a market where some investors are liquidating positions and are more concerned with selling bonds than maximizing value. In these instances, sell-side bond traders become extremely wary of taking down positions onto their own books and will act only as intermediaries as opposed to principals, thus reducing liquidity.

While risk assets were being pummeled late last week, U.S. Treasury bonds were bid higher as investors sought a safe refuge. This drove yields lower across the yield curve. The yield on the 5-year Treasury declined 16 basis points to 1.44%, the 10-year declined 15 basis points to 2.05%, and the 30-year declined 9 basis points to 2.75%. Even though credit spreads widened last week, investment-grade bonds were able to generate positive returns as the decline in underlying Treasury yields was more than enough to offset the wider credit spreads. After spending most of the year in negative territory, the Morningstar Corporate Bond Index rose enough to reach a positive return year to date. Through last Friday, the total return of our investment-grade corporate bond index is 0.32%. However, the decline in underlying interest rates was not enough to offset the wider credit spreads in the high-yield sector. After spending most of the year in positive territory, the Bank of America Merrill Lynch High Yield Master Index has dropped to a year-to-date loss of 0.32%.

Weekly High-Yield Fund Outflows Modest, but Expect More to Come
Our weekly fund flows are calculated on Wednesday nights for the trailing seven days. Through last Wednesday, outflows were a modest $0.2 billion among high-yield mutual funds and exchange-traded funds. This marked the fifth consecutive week of outflows from the asset class. While this outflow was relatively de minimis, the weekly measurement occurred while the equity markets were relatively benign. We suspect that the outflows picked up pace last Thursday and Friday as the S&P 500 fell more than 5% over those two days. The losses drove a risk-off sentiment that pervaded all asset classes and sent high-yield bond prices down almost 1 point across the board last week.

Seasonal Slowdown Reduces New Issue Volume
Only a few issuers were brave enough to issue bonds last week. Of those that did tap the capital markets, new issue concessions were especially wide in the cyclical sectors, such as energy. In those cases, credit spreads of the company's existing bonds widened out to the new issue levels as opposed to the new issues tightening in to where the existing bonds had traded. We expect that even fewer issuers will come to market this week as investment bankers will advise their clients to wait until the markets stabilize and for investors to return to their trading desks after the U.S. Labor Day holiday. Following Labor Day, we expect the new issue market will pick up pace as many companies still need to finance outstanding acquisitions and will look to raise cash to refinance maturing debt. For additional information on those issuers that we anticipate may look to sell bonds over the next few months, please see our most recent edition of Potential New Issue Supply, published Aug. 20. In this edition, we added Analog Devices (ADI) (rating: A+, wide moat), Caterpillar (CAT) (rating: A-, wide moat), Cummins (CMI) (rating: A, narrow moat), Home Depot (HD) (rating: A, wide moat), and Norfolk Southern (NSC) (rating: BBB+, wide moat).

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