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Escalating Trade War Rhetoric Weighs on Corporate Bond Market

Dave Sekera, CFA (david.sekera@morningstar.com)

The corporate bond market was hit relatively hard last Monday as the rhetoric between the United States and China escalated. Each party is exploiting the media and social media in an attempt to bolster its respective position while trade negotiations play out. Credit spreads widened significantly last Monday, but the corporate bond market attempted to recover much of the losses by Friday's close. In the investment-grade market, the average credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) ended the week 2 basis points wider at +122 basis points. In the high-yield market, the ICE BofAML High Yield Master II Index ended the week only 6 basis points wider at +407. It was a similar story in the U.S. equity market, where the S&P 500 fell hard on Monday and then clawed back a significant amount of the loss over the course of the week. For the week, the S&P 500 declined 0.74%; in China, the Shanghai Index dropped 1.94%.

Trade negotiations will continue to be an overhang on the corporate bond market for the near term as investors closely monitor how each side is publicly posturing before the G-20 meeting next month. Each party has shown a willingness to use the media and Twitter to advocate its positions and use the market's and the public's reactions to pressure the other side. Furthermore, each side has ramped up tariffs on imported goods from the other to use as bargaining chips during the negotiations. In addition to the broader set of tariffs, the Trump administration implemented trade restrictions on Huawei, a Chinese company that sells communication hardware and software. Following this pronouncement, the price on Huawei's 4% notes due 2027 dropped 3 3/8 points to 94 1/8, driving the yield on the notes up over 50 basis points to 4.92% with a resulting credit spread of +253 basis points.

While the Trump administration plays hardball with China, it is attempting to blunt the impact of the tariffs on Chinese imports by agreeing to lift tariffs on steel imports from Canada and Mexico. The administration has also decided to put off any decision on whether to implement tariffs on automobiles from Europe and Japan.

While corporate credit spreads widened out and equity markets sold off, Treasury bonds and high-quality sovereign bonds played their typical safe-haven role and traded higher as investors looked to escape the volatility in risk assets. In the U.S., interest rates dropped 6-9 basis points across the yield curve, with the 2-, 5-, 10-, and 30-year bonds dropping to 2.20%, 2.17%, 2.39%, and 2.83%, respectively, as bond prices rose. In Europe, negative interest rates were not enough to dissuade investors from flocking to Germany's sovereign bonds as prices rose enough to push the 5-year bond to an even greater negative yield of 0.51% while the yield on the 10-year bond declined to negative 0.10%. Germany's 5-year bond is trading at its most negative yield since April 2017. For context, the most negative yield at which Germany's 5-year has traded was negative 0.62% in July 2016. Germany's 10-year yield hit its most negative yield of 0.19% in July 2016 and is currently its lowest since September 2016. While investors flocked to German bonds, Italian sovereign bonds weakened after Italy's Deputy Prime Minister Matteo Salvini said he is willing to breach the European Union's deficit limits to prop up the Italian economy. The credit spread between Italy's 10-year bonds and Germany's 10-year bonds widened out to +276 basis points, the widest level since December last year.

While news headlines have concentrated on the trade dispute between the U.S. and China, negative undercurrents have been flowing in some emerging markets over the past two months. For example, the price on Argentina's 10-year bonds has dropped 10 points since mid-March. Argentina's 7 7/8% notes due 2017 have fallen to 65 5/8, which equates to a 16.05% yield and a credit spread of +1,365 basis points over equivalent-maturity U.S. Treasury bonds. While the prices on Turkey's 10-year bonds have not fallen quite as much or as low, they have also begun to show signs of stress. Since mid-March, Turkey's 7 5/8% notes due 2029 have fallen 6 5/8 points to 97 3/8, which equates to an 8.00% yield and a credit spread of +560 basis points over equivalent-maturity U.S. Treasury bonds. Both of those countries' currencies have been under significant pressure. Argentina's peso has devalued 16% against the U.S. dollar thus far this year, and the value of the Turkish lira has declined almost 13%.

Weekly High-Yield Fund Flows
For the week ended May 15, investors withdrew $2.7 billion from the high-yield asset class. This was the third-greatest weekly outflow of the past 52 weeks and sixth-largest outflow of the past two years. Based on the composition of the outflows, it appears that individual investors have been more rattled by the rhetoric surrounding the trade negotiations than institutional investors. About two thirds of last week's outflows were concentrated in high-yield open-end funds, which suffered $2.0 billion of withdrawals. Open-end mutual funds are historically seen as a proxy for individual investors, whereas exchange-traded funds are typically viewed as a proxy for institutional investor demand. Among high-yield ETFs, net unit redemptions totaled $0.7 billion.

Year to date, total inflows into the high-yield asset class have fallen $13.3 billion, consisting of $7.8 billion worth of net unit creation among high-yield exchange-traded funds and $5.5 billion of inflows across high-yield open-end mutual funds. However, the amount of inflows year to date has still not been enough to offset the amount of outflows this asset class suffered during the fourth quarter of 2018. Over the past 52 weeks, total outflows equaled $4.2 billion, driven by $6.6 billion of withdrawals across open-end mutual funds as ETFs have recuperated their outflows and more and have seen a total of $2.4 billion in new unit creation.

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