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Credit Insights

Equities Decline Following Months of Credit Market Weakness

Seasonal slowdown reduces new issue volume.

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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.

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