Second-Quarter 2018 Fixed-Income Index Review

Most fixed-income indexes continued to decline over the course of the second quarter as interest rates rose and investment-grade corporate credit spreads widened. However, with its shorter duration and higher correlation to economic growth, the high-yield sector was one of the few that registered gains this quarter.

Morningstar's Core Bond Index, our broadest measure of the fixed-income universe, declined 0.17% in the second quarter and has fallen 1.70% year to date. The decline was mainly driven by the increase in interest rates across the entire yield curve but was also under pressure from widening investment-grade corporate credit spreads. Underlying the Core Bond Index, Morningstar's Short-Term Core Bond Index was able to post a small gain of 0.22% even as short-term rates rose to their highest levels in over a decade. This gain in the second quarter helped offset earlier losses, and this index is now down only 0.17% for the year. The Intermediate Core Bond Index rose 0.10% during the quarter but has dropped 1.19% year to date. With its longer duration and greater price sensitivity to interest rates, the Long-Term Core Bond Index fell by 1.11% this quarter and had registered a 4.25% loss this year as falling bond prices from rising rates more than offset the yield carry from the underlying bonds in this index.

In the Treasury market, the Morningstar U.S. Government Bond Index increased 0.07% but has declined 1.13% so far this year. The Morningstar Agency Bond Index declined 0.04% in the quarter and 0.58% year to date. One of the bright spots this quarter was in the Treasury Inflation-Protected Securities market. As inflation measures edged up, investors looked to TIPS, which led the Morningstar TIPS Index to a gain of 0.79%. That gain was just enough to offset the losses incurred in the first quarter and the index was able to break into positive territory for the year to the tune of 0.01%.

During the second quarter, the yield on the 2-year Treasury bond rose another 26 basis points on top of the 38 basis points it rose in the first quarter. At its current yield of 2.53%, the 2-year is trading at its highest yield since August 2008. The yield on the 5-year Treasury bond rose 18 basis points to 2.74%, which rivals its highest yield since 2010. Along the long end of the curve, the yield in the 10-year Treasury rose 12 basis points to 2.86%. The yield on the 10-year briefly broke through the psychological ceiling at 3% but was quickly driven back down as concerns about a possible global trade war drove a flight to safety. At the longest end of the curve, the 30-year rose only 2 basis points to 2.99%. As short-term rates have continued to rise faster than long-term rates, the spread between the 2-year Treasury and the 10-year Treasury has since compressed to 33 basis points, representing the flattest the yield curve has registered since fall 2007.

In the corporate bond market, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) declined 0.95% this quarter as the combination of higher interest rates and wider credit spreads pushed bond prices down. Year to date, our corporate bond index has lost 3.17%. In contrast, in the high-yield market, the Bank of America Merrill Lynch High Yield Master Index rose 1.00% in the second quarter as credit spreads tightened and the higher yield carry of the index more than offset the impact of higher interest rates. This gain was enough to bring the year-to-date return for the high-yield market up to 0.08%. Among European fixed-income markets, the Morningstar European Corporate Bond Index declined 0.07% as the benefit from the decline in underlying interest rates of benchmark German bonds was not enough to offset the amount that corporate credit spreads widened. Year to date, the European Corporate Bond Index has registered a loss of 0.38%.

Once again, the emerging-markets fixed-income indexes were among the worst-performing fixed-income asset classes following significant losses in the first quarter. In the second quarter, the Morningstar Emerging Market Composite Index fell 2.62%, as the underlying Morningstar Emerging Market Sovereign Index declined 4.14% and the Morningstar Emerging Market Corporate Index fell 1.77%. Morningstar's Emerging Market High Yield Index dropped by 5.01%. Year to date, the composite index has fallen 4.25%, the sovereign index has dropped 6.08%, the corporate index has declined 3.22%, and the high-yield index has plunged by 6.21%.

Divergence Between Investment-Grade and High-Yield Corporate Credit Spread Performance
Since the end of last quarter, the average credit spread of the Morningstar Corporate Bond Index widened 13 basis points to +128, whereas in the high-yield market, over the same time period, the Bank of America Merrill Lynch High Yield Master Index has tightened 8 basis points to +371. Year to date, the investment-grade index has widened 32 basis points, whereas the high-yield index has only widened 8 basis points.

At its current level, the average credit spread in the investment-grade market is at its widest level this year and is at its highest level since the beginning of 2017. At that time, the corporate bond markets were still recovering from an earlier plunge in oil prices, which bottomed out in 2016. In contrast, the average credit spread of the high-yield index hit levels a few weeks ago that were not that far off of its tightest levels since before the 2008−09 credit crisis; however, toward the end of the second quarter, high-yield credit spreads gave back much of the outperformance from earlier in the quarter.

There are several factors in play that have led to this divergence. Investment-grade credit spreads are more susceptible to sell-offs in relation to debt-leveraged mergers and acquisitions than are high-yield spreads. Following a recent court ruling in which the U.S. Justice Department lost its attempt to block the proposed merger between  AT&T (T) and Time Warner, investment-grade portfolio managers have become increasingly concerned that the potential for megamergers and acquisitions that may not have passed antitrust regulators in the past may now be possible. For example, as soon as the Department of Justice announcement was made,  Comcast (CMCSA) commenced a bidding war with a counteroffer to acquire certain assets from  Twenty-First Century Fox , for which  Disney (DIS) had made a prior offer. Typically, mergers and acquisitions are funded with significant amounts of newly issued debt, which heighten default risk and often lead to rating downgrades. However, more often than not, high-yield companies are purchased by larger, investment-grade companies and the outstanding debt of those acquired high-yield companies are upgraded to the same rating as the acquirer.

While investment-grade has struggled, the high-yield market has outperformed thus far this year as the performance of the underlying high-yield companies are more affected by changes in economic activity, which has been robust this quarter. Whether it has been driven by the implementation of the tax cuts earlier this year, or some other reason, economic activity has been robust recently. In its most recent GDPNow estimate based on current economic metrics, the Federal Reserve Bank of Atlanta is projecting that second-quarter GDP growth will be 3.8%.

Rising interest rates have also played a significant part in the divergence between the performance of the investment-grade and high-yield markets. With their lower credit spread and longer average duration, investment-grade bond performance is more closely correlated to movements in interest rates than high-yield bonds. High-yield bonds typically have shorter durations and wider credit spreads, which are more closely tied to the performance of the underlying companies. Similar to the credit spread widening that occurred during the "taper tantrum" in mid-2013, investors are requiring additional credit spread to compensate for the risk that interest rates rise further.

The impact to corporate credit spreads on the investment-grade market from issuers that engage in large, debt-funded M&A can be seen in the performance of Disney and Comcast notes. As the bidding war for the Fox assets between the two rages on, the credit spreads for those companies' bonds have widened as investors price in a higher probability that debt leverage will increase significantly for whichever firm emerges the winner. With its higher credit rating, Disney's notes had been outperforming the market earlier this year, but this past month, Disney's 2027 notes widened 10 basis points and are 25 basis points wider than at the end of 2017. The credit spread on Comcast's 2028 notes widened 5 basis points in June and have widened 53 basis points since the end of last year.

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