Investors Regain Appetite for Corporate Bonds Following Pre-Thanksgiving Diet

In the weeks leading up to Thanksgiving, investors put themselves on a corporate bond diet, sending credit spreads wider. However, investors have now returned to the table and have not only feasted on the new issuance brought to market last week, but bid up prices in the secondary markets, tightening corporate spreads across the marketplace. New issuance in the investment-grade market was brisk, but the new transactions were easily digested. In the high-yield market, according to Bloomberg, new issuance saw the greatest weekly volume since September and the fourth-largest weekly amount priced this year. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 2 basis points to +101, and the BofA Merrill Lynch High Yield Master Index tightened 4 basis points to end the week at +363.

The tone in the marketplace improved as investors were encouraged by improving economic metrics and positive forward momentum made toward tax reform. Third-quarter gross domestic product growth was revised to an annualized 3.3% rate from the original 3.0% estimate. This is the fastest quarterly increase in GDP since the third quarter of 2014, and fourth-quarter GDP growth is expected to rise even further. The Purchasing Managers' Index and ISM Manufacturing Index are registering levels well above 50, which indicates continued economic expansion. Currently, the Federal Reserve Bank of Atlanta's GDPNow forecast for the fourth quarter is 3.5%.

With the economy expanding at an increasing rate, the Federal Reserve remains on course to continue normalizing monetary policy by raising the federal funds rate. As such, the yield on the 2-year Treasury bond continued its march ever higher; however, the yield on the 10-year Treasury bond has been holding in a relatively narrow trading band. With short term rates rising and long-term rates lagging, the general trend over the past several years for the yield curve has been to flatten, and the curve is now at its flattest level since before the global financial crisis.

In the past, when the yield curve has been flattening, it has often been an indicator of a weakening economy and in many cases portended a recession. This time around, this signal may not be foreshadowing a recession, as it is being heavily influenced by global central bank actions. In the short end of the curve, interest rates have been rising in connection with the hikes that the Federal Reserve has conducted this year, with the market pricing in another rate hike next week. According to CME Group's FedWatch Tool, the market is pricing in a 56% probability the Fed will raise short-term rates to over 1.75% by the end of 2018. According to the Fed's economic projections, the median forecast made by the Federal Reserve Board members and presidents for the end of 2018 is even higher at 2.1%.

While the Fed's monetary policy actions have been directly affecting short-term rates, the long end of the curve may be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. Even though the 10-year U.S. Treasury is yielding only 2.36%, that yield is attractive to global bond investors as the yield on Germany's 10-year bond is 0.31% and the yield on Japan's 10-year bond is barely positive at 0.04%.

This flattening trend may continue to be influenced by global central bank monetary policy. The futures markets fully expects the Fed will raise the federal funds rate next week, and the European Central Bank will not begin to taper its asset-purchase program until next year. Even then, the ECB will continue to continue to purchase EUR 30 billion per month until September 2018, which will infuse the eurozone with an additional EUR 270 billion of new money.

After suffering from six consecutive weeks of outflows, including one of the greatest weekly amounts of outflows since we began recording data, investors dipped their toes back into the high-yield sector. Inflows of $0.3 billion into the high-yield asset class consisted of $0.6 billion of inflows into exchange-traded funds offset by $0.3 billion of redemptions in open-end funds.

Over the past two months, the total amount of outflows is $5.2 billion. The preponderance of the outflows has occurred among the open-end mutual funds, while exchange-traded funds have experienced only modest redemptions. Typically, open-end funds are considered a proxy for individual investors, who are more influenced by changes in absolute yield, and ETFs are considered a proxy for institutional investor demand, which is often more correlated to changes in corporate credit spreads. Year to date, the high-yield asset class has suffered total redemptions of $11.6 billion, consisting of $15.4 billion of redemptions in open-end mutual funds offset by $3.8 billion of new unit creation in ETFs.

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