Third-Quarter Fixed-Income Market Review

Corporate credit spreads continued to tighten last week and are advancing toward multiyear lows. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 4 basis points to +104 last week, and the average credit spread of the BofA Merrill Lynch High Yield Master Index tightened 8 basis points to +356. Over the past few years, the tightest those spreads have registered was in mid-2014, when they reached +101 and +335, respectively. Before then, credit spreads have only ever been tighter in the runup to the 2008-09 credit crisis.

Investor demand for corporate bonds has been supported by solid fundamentals underlying corporate credit risk. Healthy earnings have led to improving credit metrics, and the number of actions companies have undertaken to return capital to shareholders at the expense of bondholders has remained low. However, the new issue market was relatively lackluster last week and there were not enough new issues to sate investor demand. Instead, investors turned to the secondary market to put cash to work. Trading volume in the secondary market surged and credit spreads tightened as investors bid up the price of bonds.

Interest rates on U.S. Treasury bonds rose as the demand for safe-haven investments dwindled and investors priced in a higher probability that the Federal Reserve will lift the federal funds rate one more time this year. Following the Federal Open Market Committee's September meeting, the market-implied probability that the Fed will raise the federal funds rate after the December meeting surged. According to CME Group, the probability of a rate hike in December rose to 78%, a substantial increase from the 53% probability priced into the market the prior week and the 39% probability registered one month ago.

Third-Quarter Fixed-Income Market Review
Asset markets experienced a brief blip of volatility midquarter as measured by the CBOE Volatility Index (VIX). However, the VIX subsequently dwindled back toward its historical lows as hurricanes Harvey and Irma caused only short-term market dislocations. Among geopolitical tensions, investors have become inured to North Korean rocket launches and habituated to minor terrorist attacks in Europe.

Fixed-income indexes performed well during the third quarter as the brief bout of volatility kept interest rates low, whereas ongoing healthy corporate fundamentals supported corporate credit spreads. Corporate credit markets have been buoyed by a combination of generally improving credit metrics, fewer debt-funded M&A or shareholder-enhancement programs, and the market's expectation that possible revisions to tax and regulatory policies expected to be enacted by the Trump administration will reinvigorate economic growth and boost earnings. Additionally, the fixed-income market benefited from a flattening yield curve, in which interest rates across the medium and longer end of the yield curve declined, bolstering long-term fixed-income indexes.

The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose 0.81% in the third quarter through Sept. 29. The return was generated by a combination of the yield carry on the underlying securities, the positive impact from lower long-term interest rates, and tighter credit spreads. The Morningstar Short Term Core Bond Index has risen only 0.39% thus far this quarter as rising short-term interest rates pressured returns, whereas the Morningstar Intermediate Core Bond Index and Morningstar Long Term Core Bond Index have risen 0.88% and 1.14%, respectively, benefiting from declining long-term interest rates.

Representative of the Treasury market, the Morningstar US Government Bond Index rose 0.33% and the Morningstar US Agency Bond Index rose 0.33%. After lagging much of the rest of the fixed-income universe earlier this year, Treasury Inflation-Protected Securities began to catch up to other sector returns. The Morningstar TIPS Index rose 0.82% as inflation expectations bounced off their lows in June in response to the increase in commodity prices, especially oil.

In the corporate bond market, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) rose 1.29%, supported by a slight decrease in long-term interest rates and modestly tightening credit spreads. In the high-yield market, the BofA Merrill Lynch High Yield Master Index rose 2.04%, as tightening credit spreads drove a significant amount of the performance. With its shorter duration, declining long-term interest rates did not affect the high-yield market as much as the investment-grade index. In Europe, tightening credit spreads and lower interest rates helped to bolster the Morningstar Eurobond Corporate Index, which rose 1.06%.

The emerging-markets fixed-income indexes continued to post solid returns, benefitting from the low-volatility environment and investor appetite for riskier assets. The Morningstar Emerging Market Composite Bond Index rose 2.26%, as the underlying Morningstar Emerging Market Sovereign Bond Index rose 2.40% and the Morningstar Emerging Market Corporate Bond Index rose 2.23%.

High-Yield Fund Flows
For the week ended Sept. 27, high-yield exchange-traded funds and open-end mutual funds experienced a net outflow of $0.6 billion. The $0.6 billion of inflows in the ETF sector were overwhelmed by $1.2 billion of outflows across the 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.