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Credit Insights

Corporate Credit Spreads Hitting Widest Levels in Past Two Years

Heightened tensions between the U.S. and China aren't helping.

Credit spreads in the corporate bond market weakened significantly last week as the already high tension between China and the United States rose a notch after the U.S. requested that Canada arrest the CFO of Huawei Technologies for allegedly violating sanctions with Iran. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) widened 7 basis points to end the week at +149. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 25 basis points to +450. The equity markets also took it on the chin as the S&P 500 dropped 3.82%, which was enough to push the index back into the red for the year. At their current levels, investment-grade and high-yield bonds are both at their widest levels since the beginning of December 2016. This year has not been kind to the corporate bond market, as year to date, the average spread of the investment-grade index has widened 53 basis points and the credit spread of the high-yield index has risen 87 basis points.

As investors shied away from corporate bonds and equity markets plummeted, prices on Treasury bonds surged higher. The yield on the 2-year U.S. Treasury bond declined 10 basis points to 2.71%, and the yield on the 5-year fell 16 basis points to 2.69%. In the longer end of the curve, the 10-year declined 18 basis points to 2.85%, and the 30-year decreased 18 basis points to 3.14%. As long-term bonds outperformed short-term bonds, the yield curve continued to flatten. The spread between the 2-year and the 10-year decreased 6 basis points to +14.

In addition to the heightened tensions between the U.S. and China, forecast fourth-quarter GDP growth has been slipping from earlier expectations, according to the Atlanta Federal Reserve Bank's GDPNow model. As of Friday, the forecast for fourth-quarter economic growth had dropped to 2.4% on an annualized basis, the lowest reading this metric has registered thus far this quarter.

As economic growth appears to be slowing, the market-implied probability that the Federal Reserve will hike the federal-funds rate following the Federal Open Market Committee meeting this month declined. According to the CME's FedWatch Tool, the probability that the Fed will hike the federal-funds rate by another quarter point decreased to 72% from 83% at the end of the prior week. Further, the market-implied probabilities of additional rate hikes in 2019 have declined. The market-implied probability that the federal-funds rate will end 2019 at 2.50% or higher declined to 51% from 70% at the beginning of November, and the probability that the fed-funds rate will be 2.75% or higher fell to 17%. For comparison, the probability of the fed-funds rate being 2.75% or higher at the end of 2019 had been as high as 59% at the beginning of November.

Weekly High-Yield Fund Flows
Net fund outflows were muted last week as only $0.2 billion of funds were redeemed from the high-yield sector. Among the open-end high-yield funds, investors withdrew $0.1 billion, and across the high-yield exchange-traded funds, net unit redemptions also totaled $0.1 billion. Year to date, total outflows across the high-yield sector have been decidedly negative. Thus far this year, investors have pulled $23.1 billion out of the junk bond market. Outflows from open-end funds are $15.7 billion and net unit redemptions in ETFs are $7.4 billion.

Recent Morningstar Credit Ratings Research
Last week, Morningstar Credit Ratings published a company credit report on Adobe, Inc. (AA-, stable). Our credit rating is several notches higher than the other rating agencies. In our view, Adobe's credit profile benefits from low Business Risk. The company's nearly monopolistic position in content creation software and leading position in the emerging digital marketing software space support sustainable competitive advantages that allow Adobe to generate consistently high returns on invested capital. We attribute the company's strong revenue growth and margin expansion in recent years to its cloud-first business model. The seven-year transformation from on-premises software to a cloud-based distribution platform has yielded a portfolio that attracts more users to Adobe products, which increases the firm's operating leverage. In addition, we expect Adobe will continue to employ an acquisitive strategy to increase its market share. Adobe's digital marketing acquisitions over the past decade have resulted in Adobe Experience Cloud, which we believe is the most comprehensive end-to-end digital marketing solution in the industry.

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