The corporate credit markets continued to grind higher this week as ongoing central bank accommodation, rising commodity prices and favorable supply and demand factors contributed to rising asset prices. For high yield bonds, prices have risen in seven of the past 10 days and are now providing month-to-date returns of approximately 1.15%, on pace for a ninth consecutive monthly gain.1 Despite another mild outflow from high yield bond mutual funds, high yield bond returns remained positive during the week ended October 20. After accounting for the $233.1 million in outflows witnessed over the past two weeks, high yield bond mutual funds have experienced net inflows of $1.7 billion in October and $10.9 billion in net inflows year to date.2 Accommodative central bank policy, a stable growth narrative and recovering oil prices have put high yield bonds on track for their largest annual gains since 2009. Year to date, high yield bonds are now returning approximately 16.7%, driven, in large part, by some of the worst performing sectors of 2015.1 For reference, after returning -15.0% in 2015, CCC rated bonds are currently providing year-to-date returns of approximately 31.9%.3 After returning -23.6% in 2015, high yield energy bonds are currently providing year-to-date returns of approximately 34.7%.4 Coinciding with these strong returns has been a significant amount of yield compression across the high yield bond complex. After rising above 10.0% in mid-February, high yield bond yields have since tightened to below 6%, a level not seen since May 2015.5
Senior secured loans continued to trend higher this week, benefiting from strong inflows into bank loan mutual funds and an uptick in collateralized loan obligation (CLO) issuance. Bank loan mutual funds saw a 12th consecutive weekly inflow, the longest such stretch since early 2014. At $515 million, it was the largest inflow since April 15, 2015, bringing net flows into bank loan mutual funds to $3.2 billion since the beginning of August.2 The stretch of inflows, combined with approximately $17 billion in new CLO issuance since August, has contributed to supply and demand dynamics favorable to rising senior secured loan prices and tighter yields (CLOs are one of the largest buyers of senior secured loans).6 Through October 20, senior secured loans are providing month-to-date returns of 0.59% and year-to-date returns of 8.09%.7 With oil prices holding above $50 per barrel, the energy sector has continued to drive returns.8 Energy senior secured loans returned approximately 1.52% in the week ended October 20, as the U.S. Energy Information Administration (EIA) reported a 5.25 million barrel decline in U.S. crude oil supplies in the week ended October 14, against expectations for a 2.1 million barrel gain.9,10 Similar to high yield bonds, senior secured loans are currently tracking their largest annual gain since 2009 and have undergone significant yield compression since early 2016. At just over 6%, senior secured loan yields are now sitting at a 16-month low.11
Despite growing expectations of a December rate hike, investors absorbed comments this week from central bank officials indicating they are willing to overshoot inflation targets in order to provide added stimulus to the economy. In a speech last Friday at the Federal Reserve Bank of Boston, U.S. Fed Chair Yellen said there may be some benefits in running a "'high-pressure economy,' with robust aggregate demand and a tight labor market."12 While the notion of allowing the economy to run with higher inflation held little sway over the market-implied odds of a December rate hike, it conveyed a dovish tone and raised investor expectations that subsequent rate hikes will remain gradual. Global bond prices declined on concerns that central banks may now be more willing to tolerate inflation, with the 30-year U.S. Treasury bond yield rising to its highest level since June.14 In recent weeks, rising oil prices have pushed up expectations for long-term inflation, with rebounding energy prices showing up most recently in September’s consumer price index (CPI) figures. Data this week showed headline measures of CPI rising by 0.3% in September, the fastest pace in five months.15 However, excluding food and energy prices, core consumer prices increased by a less-than-expected 0.1%, further boosting expectations of "dovish rate hike" come December.
Chart of the week: Expected diminishing returns
- China reported on Wednesday that its economy grew at a rate of 6.7% for the third quarter of 2016.16 The result was in line with investor expectations as gross domestic product growth has now remained steady for each of the first three quarters of 2016. China’s economy appears stong relative to domestic markets, yet it is on pace to record its slowest annual economic growth in more than 25 years.17
- Slow or decelerating economic growth has also been a common theme across the developed world since the financial crisis.18 As recently as its September meeting, the U.S. Federal Reserve lowered its expectation for longer-term economic growth in the United States from 2.0% to just 1.8%.19
- Reduced economic growth could translate into diminished total returns across equities and government bonds of the U.S. and Western Europe. A McKinsey Global Institute report outlined its expectations for significantly lower total returns across equity and government bond markets in the United States and Europe in the next 20 years.20
- Citing expectations for rising interest rates, lower global GDP growth and a cloudier outlook for corporate profits, McKinsey projects that total returns on U.S. equities in the next 20 years could be between 140 and 390 basis points lower than returns were for the period between 1985 and 2014.20 As the chart highlights, expected returns on other traditional asset classes in the developed world could face similar declines.20
1 Bank of America Merrill Lynch High Yield Master II Index.
2 Thomson Reuters Lipper.
3 Bank of America Merrill Lynch High Yield CCC and Lower Rated Index, which refers to bonds rated as having substantial risks or extremely speculative.
4 Bank of America Merrill Lynch High Yield Energy Index.
5 Bank of America Merrill Lynch High Yield Master II Index (yield-to-worst).
6 S&P Leveraged Commentary and Data.
7 Credit Suisse Leveraged Loan Index.
8 Federal Reserve Bank of St. Louis, http://bit.ly/292Tgue.
9 Credit Suisse Leveraged Loan Index (energy component).
10 Energy Information Administration, http://bit.ly/1V2gPZQ.
11 Credit Suisse Leveraged Loan Index (based on a three-year maturity).
12 U.S. Federal Reserve, http://www.federalreserve.gov/newsevents/speech/yellen20161014a.pdf.
13 Bloomberg, based on CME data.
14 Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/DGS30.
15 U.S. Department of Labor, http://www.bls.gov/news.release/cpi.nr0.htm.
16 National Bureau of Statistics of China, http://bit.ly/2dMYmxD.
17 The World Bank, http://bit.ly/2etiVyP.
18 IMF World Economic Outlook, http://bit.ly/2ebF5Lp.
19 Federal Reserve, http://bit.ly/2ddbqkO.
20 McKinsey Global Institute, http://bit.ly/1VUY76O.
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