A Holiday-Shortened Week, but Corporate Bond Issuers Out in Full Force

It may have been a holiday-shortened week, but corporate bond issuers were out in full force to take advantage of robust market conditions. Institutional investors report that they have ample cash reserves to put to work, interest rates remain near multiyear lows, and credit spreads have recovered from the February sell-off. The issuers we rate priced almost $35 billion of new bonds last week.

Even in the face of this wave of supply, corporate credit spreads held fairly steady last week as demand easily absorbed the new bonds. The average spread of the Morningstar Corporate Bond Index tightened 1 basis point to +149, whereas the Bank of America Merrill Lynch High Yield Index widened only 1 basis point to +609. Treasury bonds rallied, with the preponderance of the gains realized after the poor payroll report was released Friday. Interest rates declined approximately 15 basis points across the entire yield curve, and as a result, the current yield on long-dated Treasury bonds is near its lowest since early 2013.

Year to date, returns in the corporate bond market have been substantially higher than our original expectations for the year. Thus far, our investment-grade index has returned 5.94% and the high-yield index has risen 8.19%. Gains have been driven by a combination of declining interest rates, tightening credit spreads, and yield carry. Since the end of last year, Treasury bonds have rallied significantly, pushing the interest rate on 5-, 10-, and 30-year Treasury bonds down more than 50 basis points. Demand has been driven by domestic investors who are apprehensive that the stock market can make further gains as earnings expectations have diminished and by international investors who are attracted by U.S. bonds' higher yields and the safety of investing in the U.S. dollar. Year to date, the average spread on investment-grade corporate bonds has tightened 18 basis points and the average spread on high-yield bonds has declined 42 basis points. Currently, the average yield is 2.96% for our investment-grade index and 7.40% for our high-yield index.

Amount of Negative-Yielding Sovereign Bonds Continues to Grow
The Financial Times recently reported that there is now over $10 trillion of global sovereign debt securities that trade at such a high price that holding the bonds to maturity would result in a negative yield. For example, Germany's 5-year bond trades at a yield of negative 0.41%, Swiss 5-year bonds trade at negative 0.81%, and Japanese 5-year bonds trade at negative 0.22%. On the yield curve for German bonds, investors need to extend out to the 10-year maturity point to earn a positive yield; however, even those bonds currently only yield a paltry 0.07%, their lowest ever. Swiss and Japanese investors still can't generate a positive return even on long-dated bonds, as the yields on their 10-years trade at negative 0.28% and negative 0.08%, respectively.

To put negative yields in perspective, if German 5-year bonds were zero-coupon bonds (that is, did not pay any interest), the price an investor would pay today is 102.07. Over the course of the next five years, that investor would receive no interest and receive par (the face value of the bonds) in 2021, thus locking in a loss of slightly over 2% if the bonds are held to maturity. The only way to earn a positive return would be to sell those bonds at a higher price to another investor who is willing to lock in an even greater loss.

Negative yields have been driven by a combination of factors, including the European Central Bank's EUR 80 billion monthly asset-purchase program and heightened requirements for European banks to hold higher levels of capital in the form of sovereign bonds. Unlike conventional buyers of corporate bonds, the ECB is not price-sensitive. The ECB's purchases are intended to implement an easy monetary policy, as opposed to conventional purchasers, which look to maximize returns. While the banks would prefer not to lock in losses, regulatory factors compel them to do so.

This month, the ECB is expanding its asset-purchase program to include nonfinancial corporate bonds. These purchases will effectively remove supply of corporate fixed-income securities from the public markets and create new cash that must then be reinvested. As this cash is reinvested, the ECB's purchases will distort the normal market discounting function and artificially suppress credit spreads. We think the ECB's purchase of corporate bonds will have international implications as well. Many international issuers have bonds outstanding in multiple currencies. For example, for those issuers with both euro- and U.S. dollar-denominated bonds outstanding, as the euro bonds' credit spreads tighten, the credit spreads on the dollar-denominated bonds will also tighten. Investors with the ability to purchase either denomination will swap euro bonds for dollar bonds if the dollar spreads are meaningfully wider. Furthermore, we have already seen international companies issue greater amounts of corporate bonds in the European market. As companies take advantage of the lower all-in yield for euro fixed-income assets and heightened demand spurred by the ECB's purchases, the shift to euro-denominated corporate bonds may decrease the supply of dollar-denominated new issuance.

Probability of Raising Federal Funds Rate in Near Term Plummets
The market-derived probability that the Federal Reserve will raise the federal funds rate at its June meeting came crashing down after last Friday's weak jobs report. The probability declined to just under 4% from 28% the prior week and was as high as 38% after Federal Reserve Chairwoman Janet Yellen's recent public remarks about raising interest rates over the next few months. The probability that the Fed will raise rates in July fell to 31% from over 61% and the September probability fell to 48% from 71%.

Over the past few weeks, we have highlighted that the market was leery that the economic data would be strong enough to prompt the Fed to raise rates. Numerous Fed officials had been warning that rates could be rising in the near term, yet the market-derived probability remained below 50% for a June rate increase. While the Fed could lift rates at its July meeting, we continue to think that probability is low as that meeting does not have a scheduled press conference and updated economic projections. Considering the significance of raising interest rates, some believe it's highly unlikely that the Fed will raise rates without also releasing updated economic projections and holding a press conference to relay its reasoning. The Sept. 20-21 meeting does have a press conference and economic projections, but the market is essentially pricing in whether the Fed will raise rates at that meeting as a coin flip. Considering that meeting will be held in the midst of presidential campaign season and less than two months before the election, the Fed may not wish to raise rates, as it would not want its moves to been interpreted as being politically influenced. There is another meeting Nov. 1-2, but it is even more unlikely that the Federal Open Market Committee would raise rates the week before an election. That leaves the Dec. 13-14 meeting, which does have a press conference and updated economic projections.

Investors Reverse Course;
Weekly High-Yield Inflows Offset Prior Week's Outflows
Inflows into high-yield open-end mutual funds and exchange-traded funds rose by $800 million last week, almost exactly offsetting the outflow the prior week. While outflows still outpace inflows over the past month, year to date the high-yield asset class has attracted approximately $8 billion of inflows.