Limited Supply and Ongoing Demand Push Credit Spreads Tighter

The seasonal August slowdown is in full swing as a significant portion of portfolio managers, senior bond traders, and investment bankers are taking vacation time before Labor Day. Last week, trading volume slowed to some of its lowest levels of the year, and the new issue market ground to a halt; however, cash continued to pour into corporate bond mutual funds and exchange-traded funds, and portfolio managers sought out assets to put this money to work. As the thinly staffed trading desks fought over the few trades that took place, traders bid prices up in order to source bonds. On a week-over-week basis through Aug. 25, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) tightened 2 basis points to +137 and the average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 6 basis points to +514.

After gapping wider earlier this year in the face of deteriorating expectations for global economic outlook and the plunge in oil prices, the corporate credit markets have not only recovered those losses but posted very strong returns year to date. These returns have been driven by a combination of tightening corporate credit spreads and falling interest rates. For example, through Aug. 25, the Morningstar Corporate Bond Index has risen 9.07% and the Bank of America Merrill Lynch High Yield Master Index has increased 14.40%. Over this period, the average spread of the Morningstar Corporate Bond Index tightened 32 basis points and the average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 181 basis points.

As some of the last sovereign bonds in the developed markets to trade at a positive yield, Treasury bonds have risen sharply as global fixed-income investors clamor for yield. Year to date, the yield on the 5-year Treasury has tightened 59 basis points to 1.17%, the 10-year Treasury has decreased 70 basis points to 1.57%, and the 30-year Treasury has fallen 78 basis points to 2.24%. While these yields may seem low to U.S. investors, they appear quite attractive to global investors who not only are able to invest in a higher yield, but also benefit from investing in the safety of the U.S. dollar. For example, the yield on 10-year German bonds is negative 0.08%, Japanese 10-year bonds yield a negative 0.07%, and Swiss 10-year bonds yield a negative 0.52%. According to industry reports, over $12 trillion worth of debt is currently trading at prices so high that if investors purchase those bonds and hold them until maturity, they will lock in a loss. The only way an investor could earn a positive return would be to sell those bonds at an even higher price to another investor, which means the second investor would be willing to lock in an even greater loss. Even through there were significant concerns about the credit quality and economic trajectory of Italy and Spain in 2011-12 during the European sovereign debt and banking crisis, the yields on those countries’ bonds are currently below those of U.S. Treasury bonds. Italian 10-year bonds are yielding 1.13% and Spanish 10-years are yielding 0.94%, a far cry from the over 7%-plus yields they were trading at in early 2012.

Barring any unforeseen events, this week will be similarly quiet as well, as the new issue market will remain effectively closed and secondary trading volume will be kept to a minimum until after Labor Day. Fed watchers will parse every word of Fed Chair Janet Yellen’s speech over the weekend to try to divine her monetary outlook. Currently, the market-implied probability of a hike in interest rates at the September meeting is only 24%; for the December meeting, the probability has increased to 57%.

While the Federal Reserve made its first foray into normalizing monetary policy by raising the federal funds rate a quarter point in December 2015, the ultra-easy monetary policies that exist among global central banks are unabated. In fact, based on recent reports, the European Central Bank and Bank of Japan are considering loosening their already historically easy monetary policy by increasing their asset-purchase programs and/or lowering interest even further into negative territory. This easy monetary policy will continue to support the corporate bond market over the near term. With interest rates negative in the European Union and Japan, and with rates on U.K. bonds hitting all-time lows, the U.S. dollar may continue to appreciate against other developed-market currencies. As global interest rates remain near their lowest historical levels, corporate bonds have become increasingly more attractive on a relative value basis. With underlying interest rates as low as they are, the extra return provided by the credit spread on corporate bonds above the underlying benchmark bond has become an increasingly larger portion of total return.