Corporate Bond Investors Requiring Wider Spreads to Compensate for Rising Volatility

Investors went for a wild ride on the stock market roller coaster last week. The number of daily swings in the equity indexes this past week has been rarely seen since the global financial crisis 10 years ago. After several days of plus or minus 2% swings, the S&P 500 ended the week on a weak note as slower-than-expected growth punished many of the previously high-flying stocks such as Amazon.com (A, stable) and Alphabet (AA, stable) and the contagion from these declines spread across the technology sector. The S&P 500 fell almost 4% last week and is now down 0.5% for the year and almost 10% from its peak in September; however, in the larger context, considering how much the equity market ramped up during 2017, it is still up almost 19% since the end of 2016.

Although third-quarter reported earnings growth has been robust and economic growth remains relatively strong, credit spreads in the corporate bond market have widened as investors are requiring greater compensation to make up for the increase in volatility and broader decline in risk assets. In the corporate bond market, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) widened 6 basis points to +121 last week. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 34 basis points to +385. Between the heightened volatility in the markets and investors concentrating on digesting third-quarter earnings reports, the new issue market for corporate bonds was especially quiet as issuers decided to wait for calmer waters before coming to the capital markets.

Many investors had enough of the volatility in the equity and corporate bond markets and fled to the safety of the U.S. Treasury bond market. Interest rates sank as bond prices skyrocketed due to the heightened demand. By the end of the week, the yield on the two-year sank 9 basis points to 2.81%, the yield on the five-year decreased 14 basis points to 2.91%, the 10-year fell 11 basis points to 3.08%, and the 30-year contracted 7 basis points to 3.31%. Over the next few weeks, it will be instructive to watch if the 10-year Treasury bond rallies enough to dip back below the 3% psychological threshold. That had long been the psychological ceiling until it broke out in mid-September and ran up as high as 3.23% before flight-to-safety trading brought the yield back down.

Contagion from plunging prices on risk assets spread into the markets' expectation for future rate hikes by the Federal Reserve. According to the CME FedWatch Tool, the market-implied pricing for a rate hike following the December Federal Open Market Committee meeting fell to a 70% probability from 84% the prior week. The probability of another hike in 2019 fell to a 78% probability from 88%. Before this recent meltdown in the asset markets, the market-implied probability for two additional rate hikes in 2019 was as high as 61% at the beginning of October but has now slipped to 43%.

Among the global equity markets, Germany's DAX fell 3.06%, France's CAC slid 2.31%, Spain's IBEX declined 1.82%, and Italy's MIB dropped another 2.08%. Year to date, the DAX, CAC, IBEX, and MIB have posted losses of 15.91%, 9.20%, 16.15%, and 17.92%. In the European sovereign debt market, Italy's 10-year bond appears to have stabilized around 3.50%. The yield has risen a total of 143 basis points thus far this year, starting in earnest after the Italian government disclosed its original 2019 budget, which would breach the European Union's limit; however, the yield has since stabilized after the Italian government signaled that it may revise its 2019 budget in order to reduce its forecast deficit.

Recent Morningstar Credit Ratings Research
Last week, Morningstar Credit Ratings' energy team published an industry report, "Global Liquids Supply Deficit Supports Energy Pricing." In this report, Andy O'Conor, MCR's senior energy analyst, wrote that he expects average West Texas Intermediate oil prices to range between $66 and $68 per barrel in 2018 and between $65 and $70 in 2019. This is based on his expectation that subdued global exploration and production spending in the near term will continue to provide pricing support. In addition, prices will be supported by the negative impact on supply from renewed Iranian sanctions and the continuation of chaos in Venezuela. As such, commensurate with his pricing forecast, he expects that the overall credit quality of companies in the energy sector will gradually improve.

Among other research, we published a credit summary on Mylan (BBB-, negative). We recently affirmed the firm's BBB- rating; however, our outlook is negative, reflecting heightened leverage exacerbated by operational pressure stemming from a challenging pricing environment in the U.S. generics market and dwindling performance of its best-selling EpiPen brand (for severe allergic reactions). We are cautious of Mylan's ability to improve leverage after repeated delays in achieving its original leverage target (net leverage below 3 times) after its purchase of Meda in 2016.

As third-quarter earnings season continued, we published credit notes on Schlumberger (A+, negative), Halliburton (BBB+, positive), Quest Diagnostics (BBB+, stable), Biogen (A, stable), Thermo Fisher Scientific (BBB, positive), Equity Residential (A-, stable), Celgene (A-, stable), Bristol-Myers Squibb (AA-, stable), Stryker (A+, stable), and Camden Property Trust (A-, stable).

Weekly High-Yield Fund Flows
With the resumption of equity market volatility, volatility has re-emerged among fund flows in the high-yield sector, especially among institutional or fast-money accounts. These investors have looked to quickly reduce exposure to this risky asset class at any hint of trouble, but then have reversed course and plowed back into the sector at any hint of stabilization. Last week, net fund outflows totaled $2.5 billion. Among high-yield exchange-traded funds, net unit redemptions amounted to $1.9 billion. ETFs are typically considered a proxy for institutional investors as opposed to open-end funds, which are a proxy for individual investors. Across open-end funds, investors withdrew $0.7 billion of assets from the high-yield space. Year to date, total outflows across the high-yield sector have been decidedly negative. Thus far this year, investors have pulled $21.0 billion out of the junk bond market. Outflows among open-end funds is $13.8 billion and net unit redemptions in ETFs is $7.2 billion.

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