Credit Market Insights: Global Rates on the Rise

• While long-term global interest rates have generally been rising, the rate of increase picked up substantially in the U.S. following the U.S. presidential election.
• Strong demand for corporate bonds has helped push credit spreads tighter across all sectors and the average spread of the indexes are now much tighter than their long-term averages.
• Though most fixed-income sectors have given back many of the gains they generated earlier this year, the high-yield sector had been able to buck the downward trend.
• After years of downgrades outpacing upgrades, we upgraded the same number of companies as we downgraded in the fourth quarter.

In the fourth quarter, global interest rates continued to climb as investors priced in expectations that the global economy is entering a reflationary environment based on renewed economic activity. Rising rates pushed bond prices down, leading to losses in most fixed income classes. Investment-grade bonds registered losses as the amount credit spreads tightened was overwhelmed by rising rates. The high- yield sector was able to generate a small gain as junk bond credit spreads tightened enough to mitigate the impact of rising rates.

Long-term global interest rates bottomed out in July 2016 and have continued on an upward trend throughout the fourth quarter. Within the U.S., the rate of increase in interest rates picked up substantially subsequent to the U.S. presidential election on Nov. 8. In fact, the yield curve in the U.S. has risen to levels higher than where the markets began the year. The impetus for rising rates has been the market's expectation that the economy is entering a reflationary environment based on renewed economic activity that will be spurred by fiscal stimulus and tax reductions. In addition, oil prices and industrial commodities have not only stabilized, but are also trending upward.

Since the election, investors have flocked to economically sensitive assets, with those assets that have the greatest sensitivity to economic growth performing the best. For example, since Nov. 8, the average spread of the Morningstar Corporate Bond Index has tightened 8 basis points, the Bank of America Merrill Lynch High Yield Index has tightened 79 basis points, and the S&P 500 has risen 5.87% through Dec. 21. Economically sensitive commodity prices have also generally risen. For example, oil has increased more than 16% over the same time period.

As investors have bid up prices of risk assets and ratcheted up their expectations for inflation to rebound, the desire for safe-haven assets such as U.S. Treasury bonds has dwindled. Since the election, Treasury yields have increased across the yield curve anywhere from 34 to 68 basis points, depending upon the maturity date. Further pressuring interest rates, the Federal Reserve increased the federal funds rate by 25 basis points early in December. The rate hike was not a surprise as it had already been priced into the federal funds futures market; however, what did surprise the markets was the Fed's summary of economic projections that showed that the Fed is forecasting three more rate hikes by the end of 2017.

While interest rates have not risen as quickly in the other developed markets, after reaching unprecedented negative yields in other countries, long-term interest rates in Europe and Asia have at least risen back into positive albeit still abysmally low territory. For example, the yield on the 10-year German bond bottomed out at a negative (0.19)% in July and has since risen to positive 0.27% and the yield on Japan's 10-year bond bottomed out at negative (0.29)% and has risen to positive 0.06%.

With interest rates surging higher, those fixed-income sectors that are highly correlated to U.S. Treasury prices gave back much of their year-to-date gains during the fourth quarter. For example, the Morningstar U.S. Government Bond Index pared 4.42% thus far this quarter, and is now only up 0.42% year to date.

Within the corporate bond sector, credit spreads tightened, helping to offset some of the impact of rising rates. However, it wasn't enough to overcome the downward pressure on bond prices from rising interest rates. The average spread of the Morningstar Corporate Bond Index tightened 10 basis points thus far this quarter to +129, but the yield on the 10-year Treasury has risen 94 basis points, overwhelming the amount that investment-grade corporate credit spreads tightened. A such, the Morningstar Corporate Bond Index lost 3.62% quarter to date and is now only up 5.06% for the year. Conversely, in the high-yield market, credit spreads have tightened enough this quarter to mitigate the negative impact of rising interest rates. The average credit spread of the Bank of America Merrill Lynch High Yield Master Index tightened 78 basis points to +419, leading the index to a 1.41% gain quarter to date and healthy return of 16.95% year to date.

Although emerging markets typically perform well in an environment where investors are looking to increase risk to their portfolios, emerging markets were not able to escape the negative impacts from rising rates and were further pressured by the rapidly escalating value of the U.S. dollar. Quarter to date, the Morningstar Emerging Market Composite Index has declined 3.52%. While this offsets some of the gains registered earlier in the year, the index still remains up 9.46% year to date.

With interest rates rising and investors expecting better economic growth ahead, many U.S. fixed-income investors revised their investment strategies to increase their allocation to corporate bonds and reduce their allocation to Treasury bonds. In addition, attracted by the higher all-in yields offered in the U.S., foreign investors remain significant buyers of U.S. dollar-denominated corporate bonds. Although new-issue supply remains robust, the combined demand from both U.S. and foreign investors has outstripped supply and led to tightening corporate credit spreads.

Much of corporate credit spreads' tightening of this year was incurred in those economically sensitive sectors that experienced the brunt of losses in 2015 and early 2016. There are four sectors that have tightened more than the overall index: gas pipelines, basic industries, energy, and media. Gas pipelines have outperformed as the price of natural gas has soared 22% this quarter in response to the early onset of unusually cold weather this winter. Basic materials has benefited from a rapid recovery in prices this year. For example, coking coal prices have tripled, iron ore and thermal coal have more than doubled, and copper has increased approximately 25% this year. After having fallen to below $30 per barrel in Feb. 2016, oil has rebounded to over $52 per barrel, which has significantly reduced near-term bankruptcy risk within the energy sector.

In February 2016, corporate credit spreads reached their widest levels since 2012, when the market was recuperating from the European sovereign debt and banking crisis. However, these lofty spreads didn't last long and have been tightening ever since. In fact, demand for corporate bonds has been so great, that both the investment-grade and high- yield indexes are now trading at levels that are much tighter than their long-term historical averages. Since the end of 1998, the average spread of our investment-grade index is +168, and since the end of 1996, the high-yield index has averaged +580. As of Dec. 21, the average spread of the Morningstar Corporate Bond Index is +129 and the average spread of the Bank of America Merrill Lynch High Yield Master Index is +419. As a point of reference, the tightest that the Morningstar Corporate Bond Index has ever traded was at +80 in February 2007 and the tightest the high-yield index registered was +241 in June 2007.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds' Withdrawal

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