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More Corporate Bond Volatility to Come

While the U.S. economy should hold its course, slowing economic growth in China and commodity price pressures will continue to impact corporate credit spreads, says Morningstar’s Dave Sekera.

More Corporate Bond Volatility to Come

Dave Sekera: During the first few weeks of the year, interest rates declined around the world as investors sought the safety of developed-market sovereign bonds as a refuge from plummeting commodity prices. Yet, even after commodities rose higher late in the quarter, those same sovereign bonds held their gains in response to the ECB’s expanded easy monetary policy.

The Morningstar Corporate Bond Index gained 3.87% in the first quarter, but it was a rough ride intra-quarter as plunging oil prices and lower commodity prices pushed credit spreads significantly wider early in the year. However, oil and commodity prices staged a late-quarter recovery with oil prices recuperating almost all of the losses realized since the end of last year. Credit spreads also recovered, ending the quarter about where they began.

In the beginning of March, we stated in our Credit Weekly publication that considering credit spreads were near levels that were more consistent with recessionary periods, the then-emerging snap-back rally in corporate credit spreads had further to run. Since the end of February, the average corporate credit spread of the Morningstar Corporate Bond Index has tightened 42 basis points to +162 basis points over Treasuries, which is near the long-term average for the index. In the high-yield space, the Bank of America Merrill Lynch High Yield Index had tightened 62 basis points to +713.

For the second quarter of 2016, many of the same dynamics that impacted the first quarter are still in place and we think investors should brace for another bout of corporate credit spread volatility. Morningstar’s director of economic analysis Robert Johnson, forecasts that the U.S. economy will continue to expand at an average annualized pace between 2.0% and 2.5% in 2016. Yet, while the U.S. economy should hold its course, we expect economic growth in China and the emerging markets will continue to wane. In addition, volatility will continue to emanate from oil prices. Andy O'Conor, Morningstar's credit analyst covering the energy sector, believes that ongoing overproduction in the sector will continue to pressure oil prices in the near term.

In such a volatile environment, investors should look to utilize the sell-offs to increase exposures in those sectors whose underlying credit-risk dynamics are unaffected by the downturn in commodity prices, but in which credit spreads widen in sympathy with overall market movement.

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