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Credit Insights

Investor Demand for Corporate Bonds Leads to Further Credit Spread Tightening

Weekly high-yield fund flows normalize after prior week's surge.

Investor demand for corporate bonds continued to push credit spreads tighter last week. In the investment-grade bond market, the average spread of the Morningstar Corporate Bond Index tightened 2 basis points to +128. In the high-yield market, the spread of the ICE BofAML High Yield Master II Index tightened 20 basis points to +412. While investors were willing to pay slightly tighter credit spreads for high-quality bonds, the amount of credit spread tightening lagged the movement in lower-quality bonds. Typically, short-term movement in the investment-grade bond market is correlated with changes in interest rates. As U.S. Treasury prices softened last week, investors were unwilling to chase spreads at tighter levels. In addition, according to Bloomberg, a heavy dose of new issue supply in the primary market—over $38 billion—provided enough new bonds to fill demand. Between the holiday-shortened week and issuers already completing their financing requirements following the exit from quiet periods after releasing earnings, Bloomberg forecasts that new issue supply will decrease to a more normalized range this week of $20 billion-$25 billion.

While market technical factors precluded investment-grade bonds from tightening much further, these same factors did not hold back the high-yield market. Historically, short-term movement in the high-yield bond market has been more closely correlated with changes in the equity market, and last week was no exception. Not only did the S&P 500 climb 2.50%, but many European markets rose even more. For example, Germany's DAX rose 3.60% and the French CAC rose 3.86%. One of the factors that helped boost global equity markets was the rumor that weakening economic activity in the European Union may spur the European Central Bank to restart its quantitative easing program. Another factor was the opinion that the Federal Reserve probably won't raise the federal-funds rate for the rest of the year.

Over the past few weeks, we have highlighted myriad economic and political risks that have cooled the Fed's outlook and led the futures market to price in an increasing probability that the Fed will be on hold for the rest of 2019. According to the CME's FedWatch Tool, the market-implied probability that the federal-funds rate will end 2019 at the current 2.25%-2.50% range is 84%. Recently released economic metrics have supported the view that the Fed will be on hold for the foreseeable future. The December retail sales report revealed that sales fell 1.2% from the prior month. This decline is reportedly the sharpest month-over-month contraction since September 2009 and a significant contrast from the consensus estimate, which expected a slight gain. Following the retail sales report, the Atlanta Fed cut its GDPNow forecast for the fourth quarter of 2018 to 1.5% from 2.7%.

Weekly High-Yield Fund Flows Normalize After Prior Week's Surge
High-yield fund inflows subsided last week after posting their second-greatest weekly inflow the prior week. Combined net inflows into high-yield open-end mutual funds and high-yield exchange-traded funds were $0.6 billion last week, consisting of $0.2 billion of inflows into mutual funds and $0.4 billion of net unit creation across ETFs.

Over the trailing 52 weeks, high-yield fund flows remain decidedly negative. Over this time, outflows total $10.1 billion, predominately due to $10.9 billion of outflows among open-end funds, which have only been minimally offset by $0.8 billion of net unit creation among high-yield ETFs. However, the recent trend in the high-yield market has turned the corner. Year to date, total inflows are $9.1 billion, consisting of $4.3 billion of inflows among open-end funds and $4.8 billion of net unit creation among high-yield ETFs.

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