International Investors Searching for Yield in U.S. Corporate Bond Market
They're looking for positive returns wherever they can find them.
Corporate credit spreads were largely unchanged last week. In the investment-grade market, the average spread of the Morningstar Corporate Bond Index held steady at +115. In the high-yield market, the ICE BofAML High Yield Master II Index widened 5 basis points to +407.
While corporate credit spreads were relatively unchanged at the index level, it wasn't for a lack of investors trying to find bonds available for sale. According to Wall Street traders, international investors were actively searching for offers. As over $12 trillion of debt in Europe is trading at a negative yield, and even some high-yield bonds are reportedly doing so, international investors are searching for positive returns wherever they can find them.
European accounts were reportedly looking for longer-duration corporate bonds rated single A and better, while Japanese investors were searching for intermediate-duration bonds rated mid-BBB and better. These international investors were not buying indiscriminately, however. According to one trader, market action had the feel of being an up-in-quality trade: Investors concerned about slowing economic activity, which could pressure credit ratings of debt in the lower BBB category, were looking to swap out of lower-rated debt and into higher-rated bonds. This trader reported that investors were shying away from issuers that had leveraged up their balance sheets to fund acquisitions and are currently rated BBB-. Many of these issuers have debt leverage metrics that are more typically indicative of below-investment-grade ratings. In these instances, the existing investment-grade rating is predicated on the issuer quickly paying down debt toward more normalized levels for the rating category. If an economic slowdown or recession were to disrupt the repayment of debt or pressure the firm's cash flows, these bonds could be downgraded to high yield. The resulting widening of the credit spreads to junk bond levels would significantly lower bond prices and impair the performance of asset managers with exposure to these issuers.
The new issue market was unable to satisfy much of this excess demand from international investors. According to Bloomberg, only $4.5 billion of new investment-grade bonds was issued last week, and issuance may remain muted as investment-grade syndicate desks expect only $20 billion of new issuance this week.
The S&P 500 was unable to hold its ground and sank back below 3,000 last week. Second-quarter results have been mixed, as many companies have been able to beat earnings estimates, but considering that many of those estimates had recently been lowered, those beats have been a hollow victory. Stocks tried to recover lost ground midweek after comments made by the president of the Federal Reserve Bank of New York were interpreted by the markets as not only guaranteeing a rate cut in July, but also a higher probability that the Fed would cut rates by 50 basis points. However, the Fed downplayed the chance for a 50-basis-point cut and the S&P 500 sank on Friday, ending the week down 1.23%. If the Fed does lower the federal-funds rate next week, this will be the first interest-rate cut since the depths of the global financial crisis at the end of 2008.
The case for a 50-basis-point cut has been diminished by recently reported economic metrics that have generally been stronger than expected. For example, the Commerce Department reported that retail sales in June rose 0.4%, a much better reading than consensus expectations of 0.1%. The headline retail sales report would have even been higher had falling gasoline costs not been a drag on overall sales. Based on this result, it appears that consumer spending grew at over a 4% annualized rate in the second quarter. In addition, the June jobs report earlier this month was higher than expected. After including these metrics in its model, the Federal Reserve Bank of Atlanta increased its forecast for second-quarter GDP from the prior week. As of July 17, the GDPNow model estimate for the seasonally adjusted annual rate of real GDP growth in the second quarter is 1.6%.
While the markets are pricing in a hike to the fed-funds rate following the Federal Open Market Committee meeting July 30-31, we note that this meeting is not scheduled to release an updated Summary of Economic Projections. The next Summary of Economic Projections is scheduled to be released in conjunction with the Sept. 17-18 meeting.
The United States is not alone in its pivot toward easing monetary policy. The European Central Bank has also been signaling its intentions to further ease monetary policy in the European Union. The ECB is reportedly considering cutting its already negative short-term interest rate, instituting additional bond-buying programs, and/or providing enhanced guidance that it could leave its short-term interest rate at a negative yield for even longer.
Weekly High-Yield Fund Flows
High-yield inflows posted their sixth consecutive weekly inflow last week as investors continued to be comfortable with taking on additional credit risk in the search for additional yield. For the week ended July 17, high-yield inflows registered $0.4 billion. Inflows were slightly weighted more toward high-yield open-end mutual funds, which realized inflows of $0.3 billion. Net unit creation among high-yield exchange-traded funds was only $0.1 billion.
Year to date, inflows into the high-yield asset class total $16.8 billion, consisting of $11.0 billion of net unit creation among high-yield ETFs and $5.8 billion of inflows across high-yield open-end mutual funds.
Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization ("NRSRO"). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com.