Credit Markets: Volatility and Spreads to Remain Elevated

• Spreads in investment grade and high yield remain near year-to-date wides.
• Weak commodities prices are pushing some high-yield credits toward default.
• The first Fed tightening cycle in almost a decade is upon us.
• Downgrades far outpaced upgrades in the quarter, and the outlook is for more of the same.
• Steady but low GDP and a strong consumer provide support to credit.

We expect volatility to remain elevated in the first quarter, with spreads staying range-bound at or near year-to-date wides. We expect the ongoing headwinds of weak commodity prices and debt-funded mergers and acquisitions to continue. Pressure on the energy and metals and mining sectors, which got hit hard in the fourth quarter, does not look likely to abate, per our sector analysts. Still, we expect mild economic growth to continue domestically, which, along with spreads at above-average levels, should provide support to valuations.

We view the investment-grade market as fair to slightly expensive, even at levels slightly wider than long-term averages, given weaker credit quality and poor technicals. Investment grade has been whipped around this year by a number of factors, including record M&A activity, and spreads of +168 basis points as of Dec. 16 on the Morningstar Corporate Bond Index are +28 bps wider on the year and wide of the +160 bps long-term average (excluding the financial crisis). Spreads are also well wide of the recent tights of +101 bps in July 2014.

With negative top-line growth and operating margin pressure, companies have looked to other sources to boost growth and value, including massive share repurchases. This has led to record new bond issuance, which has also contributed to spread widening over the course of the year. However, the index is trading about +20 bps inside of its wide level for the year of +188 bps reached on Sept. 30, whereas the high-yield market is about +30 bps wider since then. This is partially due to the composition of the investment-grade index, which has fewer energy or metals and mining names and many more financials. The latter performed very well in November.

We expect M&A to taper off from record levels in 2016, which could eventually ease the burden on the investment-grade market. However, new issue supply from deals announced but not yet funded remains substantial and could put pressure on spreads in the first quarter. We also expect fourth-quarter earnings results to largely be mixed, given the confluence of global economic weakness and pressure from declining prices in the commodity sectors. Management guidance for 2016 revenue and earnings has the potential to disappoint, in our view.

Finally, our list of ratings under review with negative implications (UR-) far exceeds our list of ratings under review with positive implications (UR+), and our downgrade/upgrade ratio remains heavily slanted to recent downgrades, suggesting that credit quality is weakening. As such, we see spreads as most likely to be range-bound, with widening out to the year-to-date wides as possible.

We view high yield as fairly valued to slightly expensive near year-to-date wide levels as we see the market pricing in a substantial ramp in defaults from the energy and metals and mining sectors. High-yield spreads, as measured by the BofA Merrill Lynch High Yield Master II Index, reached new year-to-date wides of +683 basis points on Oct. 2, tightened over 100 bps a month later, and then rose to a new high of +733 bps as of Dec. 14 before settling back to +698 bps on Dec. 16. Yields are also near year-to-date wides at 8.79%, driven by ongoing weakness in the energy and metals and mining sectors.

We see the high-yield market as remaining bifurcated, with some of the more consumer-oriented sectors trading at tight but sustainable yields and some of the commodity or industrial sectors trading at yields well wide of the index. For example, the food, beverage, and tobacco sector of the index yields just over 6% despite an average rating of high B. The energy sector yields almost 15% despite a similar high B average rating.

The latter will also eventually suffer elevated defaults, and we expect overall market default rates to increase well above the 2%-3% range we have seen, although probably not in the first quarter. As such, high-yield performance will continue to be driven by sector selection, and we lean toward more conservative sectors. We also worry about the recent trends of sharp fund outflows combined with poor liquidity leading to gap-downs in bond pricing. This has mostly permeated the weaker sectors, but if fund managers are forced to look to higher-quality names to raise cash, this could add pressure to the whole market.

Supportive of credit is the economic outlook provided by Robert Johnson, Morningstar's director of economic analysis. He continues to forecast that real GDP will expand 2%-2.5% in 2016, similar to the level that he accurately predicted over the past several quarters. Positive slow economic growth despite global headwinds, a gradually improving jobs story, and a boost to consumers from lower commodity prices can all support corporate credit.

Potentially complicating the outlook is the fact that we are at the front end of the first Federal Reserve tightening schedule since 2006. With much of the rest of the world easing or providing artificial support to markets, this could result in ongoing support to the dollar but stunt revenue and operating income at global U.S. companies. Still, we see the Fed's approach as likely to be very methodical, with strategic rate hikes over an extended period, assuming the economy holds up. Initially, we don't believe this will have a meaningful impact on the important two thirds of the economy that remains in growth mode, the consumer. We don't expect any Fed moves to substantially drive intermediate- or long-term interest rates higher, although that remains a risk as investors could move to the sidelines on corporate bonds similar to when the taper tantrum occurred in 2013.

Fed Expected to Take a Go-Slow Approach on Tightening After seven years of a near-zero interest rate policy, the U.S. Federal Reserve raised the short-term federal-funds rate above 0% with its recent 25-basis-point increase, which was widely anticipated. The rise in the fed-funds rate is the first in nine years and is the beginning of what the Fed hopes to be an interest rate normalization process after years of emergency monetary measures. However, even the Fed acknowledges the process will probably be slow and gradual, with the U.S. economy grinding out expected growth in the 2%-2.5% range when measured by GDP. This begins the sixth tightening cycle since 1979; traders are currently expecting another two or three rate increases in 2016.

The latest U.S. core CPI (year over year) was measured at 2.0%. This statistic has averaged 1.7% over the past seven years and, after considering hedonic adjustments for quality changes and substitution effects by the Bureau of Labor Statistics in calculating, it is effectively at the Fed's goal of 2%. In other words, the real money interest rate has been at negative 2% for seven years. Moreover, the Taylor rule model, a monetary-policy rule that stipulates how much a central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions, states that the fed-funds rate should already be at 2.5%. The move at this point to normalization is very much desired by the members of the Fed; however, it is in uncharted waters after the unprecedented monetary measures of the past seven years, which among other things added an extra $3 trillion to the Fed's monetary base.

Some believe that this rate increase may be limited with the economy less than robust and high-yield credit markets signaling some distress in the economy. Additionally, there is a developed-market central bank divergence in monetary policy, with the European Central Bank and Bank of Japan loosening monetary policy and the Fed strengthening. Continued rising fed-funds rates would increase this divergence and further strengthen an already-strong U.S. dollar, which would further pressure U.S. multinational profits and emerging-markets economies, depending on export of commodities. Finally, 2016 is a presidential election year, and while there exists precedent for rising rates (fed funds) in such years, it usually occurs when the U.S. economy is much stronger.

One thing, among many, that the data-dependent Fed will be monitoring is the 2-year - 10-year U.S. Treasury spread. Generally speaking, when this spread goes to zero or negative, the economy typically enters into recession. Four of the past five tightening cycles since 1979 eventually produced a zero or negative spread and a subsequent recession.

We believe the Fed will be tentative and slow with its rate rises, observing how they affect longer Treasury rates as well as general economic and credit conditions. In particular, the Fed will closely monitor how rising short-term rates affect overall credit growth trends in the United States. Also, we believe the Fed would be quite tolerant of inflation above 2% for a while as a trade-off for a strengthening economy.

Contributed by Sean Sexton, CFA

High-Yield Outlook Spurred by renewed weakness in energy and commodity prices, credit spreads on high-yield corporate bonds resumed a widening trend over the past few weeks, reversing a spread recovery throughout early November. For the quarter through Dec. 16, the BofA Merrill Lynch High Yield Index has returned negative 2.4% and is on track to suffer its first losing year since 2008. For the year to date, the return on the BofA Merrill Lynch High Yield Index is now down 4.9%. For comparison, the S&P 500 is still up 3.0% year to date including dividends, and investment-grade corporates are down 0.7% on a total return basis.

Weakness in high-yield spreads has had a material impact on several recent new issue transactions over the past few months. For example, Frontier Communications' $6.6 billion issuance of senior notes in late September met with a very lukewarm reception, pushing 10-year pricing to 11% at issue. In secondary market trading during October, the price on the new Frontier 10-year senior notes declined, with the corresponding yield widening out to as much as 12% before finding support. However, after subsequently tightening into around 10%, it has since traded back out toward the wides.

Also affected was a planned senior note financing to fund Carlyle Group's pending acquisition of Symantec's Veritas information management business, which has been delayed by weak high-yield market conditions. As a result, the banks that committed to short-term bridge financing are unable to reduce their exposure. This in turn has negatively affected leveraged loan pricing, particularly for highly speculative credits. Over the past three months, the average bid price on large corporate loans has slid 2 points to an average of $95 according to data from S&P Capital IQ. The S&P/LSTA Top 100 Loan Index lost 0.88% during November, and year to date it is up just 0.4% compared with the BofA Merrill Lynch High Yield Index, which is down 4.9%. We also attribute the weak recent performance in loans to a technical squeeze as a result of the convergence of a higher supply of new loans last month, concurrent with a slowdown in demand for paper, particularly in the lower rating categories.

As the year has progressed, higher spreads have dramatically slowed the pace of high-yield new issuance, which is now down 11% compared with a year ago. This is a marked slowdown from earlier this year as issuance volume in the first quarter of 2015 was up 44% above the prior year. Year to date, CCC rated corporate debt delivered the worst performance, with a negative return of over 15% as demand for the most speculative credit has dried up. This effect has been exacerbated by migration into the category from ratings downgrades. Meanwhile, operating pressures continue to mount for many high-yield names, particularly those in the energy and basic materials sectors.

High-yield outflows have risen sharply as investors have fled the high-yield market. High-yield mutual funds and exchange-traded funds registered a $3.3 billion outflow the first week of December, the second-greatest outflow over the past 52 weeks, dominated by open-end fund redemptions. In recent weeks, two high-yield funds, Third Avenue's $2.4 billion Focused Credit Fund and a $400 million distressed credit fund managed by Stone Lion Capital Partners, were reported to have suspended redemptions as asset liquidity has deteriorated.

In 2016, we expect default rates to increase, and we also expect additional downward rating migration. As we head into the first quarter, we believe investor sentiment is more likely to remain risk averse. We expect higher-quality to continue to outperform low-quality paper, assuming energy and commodity prices remain weak. However, the desire to reduce exposure and access liquidity across the asset class is likely to suppress returns for even the strongest names. In this context, we currently view high-yield valuations to be fair to slightly overvalued.

Looking ahead to 2016, the 800-pound gorilla in the room is Dell's proposed leveraged buyout of EMC for $67 billion. The transaction, if consummated, will involve $59 billion of debt, currently in the form of committed and syndicated bridge loan financing. For comparison, the largest high-yield bond deal so far this year was Charter Communications' $15.5 billion to finance its acquisition of Time Warner Cable. The Dell transaction is targeted to close in mid-2016 but could face challenging financial market conditions if current trends persist. However, even if market conditions improve, the sheer size of any public refinancing of this debt package could quickly overwhelm available market demand for paper, crowding out other potential issuance and keeping pressure on secondary yields.

Contributed by Michael Dimler, CFA

More Quarter-End Insights

Market Outlook: Late-Cycle Behavior?

Economic Outlook: Escape Velocity Not in the Cards for U.S. Growth

Basic Materials: Fates Tied to Faltering China

Consumer Cyclical: Consumer Volatility Creates Investment Opportunities

Consumer Defensive: Bargains Harder to Come By

Energy: Pain Persists as OPEC Refuses to Play White Knight

Financial Services and Real Estate: Fiduciary Standard Rule Could Have Drastic Impact

Healthcare: Even After Uptick, Some Great Values Remain

Industrials: Unsettled Global Economy Serves Up Individual Stock Bargains

Tech & Telecom: Cord-Cutting and Programmatic Advertising Trends Continue

Utilities: Don't Fear the Fed--Yield and Growth Still Look Good After 2015 Slump