Not Yet St. Patrick's Day, but Verizon Goes Green
Corporate bond market runs out of steam midweek.
St. Patrick's Day is still a month away, but Verizon Communications (BBB, stable) got an early start last week as it issued its first "green" bond. According to the International Capital Market Association, "Green Bonds enable capital-raising and investment for new and existing projects with environmental benefits." To be considered a green bond, the issuer commits to using the proceeds from the bond issue for projects that will enhance its climate or environmental profile. Currently, there are no governmental regulations that stipulate what a company must do to designate a bond issue as a green bond, but the ICMA has published Green Bond Principles 2018, which outlines its voluntary process guidelines for issuing green bonds. Typically, the issuer will solicit a second-party opinion to provide investors with its assessment as to the firm's adherence to the ICMA's four core components of the Green Bond Principles. In the case of this bond issuance from Verizon, the second-party opinion was provided by Sustainalytics, a leading independent provider of environmental, social, and corporate governance research, ratings, and analytics. The opinion can be found here: https://www.sustainalytics.com/green-bond-second-party-opinions/
The green bond issued by Verizon was a $1 billion, 10-year note offering that was priced at a spread of +120 basis points over Treasuries. Demand for the new notes was off the charts; Bloomberg reported that the note offering was 8 times oversubscribed (meaning that there was $8 billion of orders for the $1 billion offering). This is more than double the average oversubscription level in 2018. In the secondary market, the heightened demand immediately drove the price higher to an equivalent of +118 basis points over Treasuries, and the bonds have continued to trade in that context. One bond trader said he thought the bonds were priced about 5 basis points tighter than an equivalent non-green bond would have priced for the same maturity. Before this offering, Verizon's existing 2028 notes were also trading around +120, which means that the green bonds were priced with no new issue concession and no additional spread for the curve.
The global market for green bonds has been growing rapidly, with European markets leading the way. While the United States may be lagging, the demand for green bonds has been steadily growing domestically in conjunction with investors' appetite to invest in companies that focus on improving environmental, social, and governance risk factors in their business. As investor demand for ESG-dedicated funds grows and issuers recognize the benefits to their corporate image as well as some potential cost savings on their interest expense, we expect the green bond market will grow significantly in the U.S. Other companies that have issued green bonds denominated in U.S. dollars include Apple (AA-, negative), Boston Properties (A-, stable), Kilroy Realty Corp. (BBB, stable), and Alexandria Real Estate Equities Inc (BBB+, stable).
Corporate Bond Market Runs Out of Steam Midweek
Corporate credit spreads initially tightened at the beginning of the week as investors drove bond prices higher but began to run out of steam by the middle of the week. In the investment-grade corporate bond market, the average spread of the Morningstar Corporate Bond Index had tightened as much as 5 basis points early in the week but gave back that ground and ended the week where it began at +130.
In the high-yield market, the average credit spread of the ICE BofAML High Yield Master Index had tightened as much as 16 basis points but gave back the gains and then some to end the week at +432, which was 3 basis points wider compared with the prior week. Considering that since the end of last year, investment-grade credit spreads have tightened 27 basis points and high-yield spreads have tightened 101 basis points, it's not surprising to see the market pause before it decides which direction is next.
Last week, we noted that Treasury bonds rallied as the Federal Reserve changed its stance from a tightening bias to neutral. Interest rates continued to drop and are now lower than where we began the year. The yields on the 2-, 5-, 10-, and 30-year U.S. Treasury bonds fell 3, 6, 5, and 5 basis points, respectively, to 2.47%, 2.44%, 2.63%, and 2.98%.
Following the January meeting of the Federal Open Market Committee, Federal Reserve Chairman Jerome Powell said the case for raising the federal-funds rate further has weakened. Myriad economic risks have cooled the Fed's outlook. Although the Atlanta Fed's GDPNow forecast for first-quarter GDP growth is 2.7%, economists are concerned that contagion from slowing growth in China and economic weakness in Europe may negatively affect U.S. economic growth. Highlighting the weakness in Europe, Italy, the European Union's third-largest economy, has officially entered a recession with two consecutive quarters of economic contraction. Closer to home, exceptionally cold weather in the Midwest and the impact of the government shutdown have heightened the downside risk to economic growth in the first quarter. Further, economic growth could be damped from ongoing trade disputes, a possible hard Brexit without a trade agreement, and the potential for additional U.S. government shutdowns if Congress and the executive branch are unable to reach an agreement on spending.
Considering all of these factors, following the January meeting, the Fed stated in its press release, "In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal-funds rate may be appropriate to support these outcomes." The change in language to "patient" is generally interpreted by the market to imply that the Fed will not raise interest rates any further in the short term but will evaluate economic data before it decides its next course of action. Economists expect that the Fed will telegraph its intentions to the market before any further changes in the federal-funds rate, either up or down. While the market currently expects that the federal-funds rate will be on hold though the end of 2019, the futures market has begun to price in a higher probability that the next move in the federal-funds rate will be down. According to the CME's FedWatch Tool, the probability that the federal-funds rate will end 2019 at the current range of 2.25%-2.50% is 80%, a decline from an 89% probability one week ago. The probability that the Fed will cut the federal-funds rate by the end of the year rose to 17% from 11% last week. There is only a 3% probability that the Fed will hike short-term rates over the course of the year. That probability had been as high as 33% as recently as mid-January.
Between the decline in underlying interest rates and tightening corporate credit spreads, both the investment-grade and high-yield bond indexes have posted strong returns for being less than six weeks into the year. Through last Friday, the Morningstar Corporate Bond Index has risen 2.64% and the ICE BofAML US High Yield Master Index has risen 4.89%.
Weekly High-Yield Fund Flows Reach Second-Greatest Inflow on Record
High-yield fund inflows surged to their second-greatest weekly inflow since we started collecting this data in June 2009. Combined net inflows into high-yield open-end mutual funds and high-yield exchange-traded funds reached $4.6 billion last week, consisting of $2.7 billion of inflows into mutual funds and $1.9 billion of net unit creation across ETFs.
The single-greatest amount of inflows occurred in February 2016, when weekly high-yield inflows reached $5.8 billion. The third- and fourth-greatest weekly inflows occurred in October 2011 and July 2016 with $4.3 billion each. There have not been any other instances in which weekly inflows breached the $4.0 billion mark.
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