The corporate credit markets were relatively stable this week as investors appeared to recalibrate long-run inflation expectations and grew more confident that the U.S. Federal Reserve (U.S. Fed) will raise interest rates in December. With U.S. government bond yields rising across the curve, investment grade bonds posted a return of approximately -0.68% in the week ended October 27, as investors appeared to eschew longer-duration investments in favor of those whose values are less likely to be affected by shifting interest rate expectations.1 Weakening towards week’s end, high yield bonds generated returns of -0.33% in the week ended October 27, with another modest outflow from high yield bond mutual funds and an uptick in new high yield bond issuance weighing slightly on the broad index.2 Nevertheless, with a month-to-date return of 0.81%, high yield bond returns remain on pace for a ninth consecutive monthly gain and their largest annual gains since 2009.2 Year to date, high yield bonds are now returning approximately 16.26%, making the asset class one of the better-performing fixed income investments of 2016.2 By comparison, investment grade bonds have provided year-to-date gains of approximately 8.18%, and senior secured loans have provided year-to-date gains of approximately 8.25%.1,3 Amid an increased likelihood that the U.S. Fed will raise interest rates before the end of the year, bank loan mutual funds continue to see inflows, with another $291 million moving into the asset class in the week ended October 26.4 It was the 13th consecutive weekly inflow, bringing net flows into bank loan mutual funds to more than $3.7 billion since the beginning of August.4
Global bond yields rose around the world this week, with the U.S. 10-year note yield and the 10-year German bund yield both rising to their highest level in nearly six months.5,6 The combination of low global growth, subdued inflation expectations and ongoing accommodative central bank policies has helped keep bond yields low. However, the narrative appears to have shifted slightly over the past few weeks amid some increased economic optimism and signals that the U.S. central bank’s plan to tighten interest rates remains on track. Other key factors influencing the direction of global bond yields this week included stronger-than-expected third-quarter U.K. GDP figures, a slight rise in inflation expectations, and some uncertainty over the willingness of global central banks to extend their stimulus efforts.7 Emblematic of this shift are a steepening yield curve and a rise in the 10-year break-even rate, which rose to 1.75% this week from a low of 1.36% in June, suggesting investors expect the U.S. inflation rate to be 1.75% over the next 10 years.8 Though slight, this shift in expectations was felt across longer-duration investments, putting the U.S. 30-year government bond on pace for its worst monthly performance since February 2015.9
Though the U.S. economy remains somewhat sluggish, an acceleration in third-quarter GDP is likely to provide the U.S. Federal Reserve with further impetus to raise rates in December. In what was investors’ first look at U.S. economic output during the latest quarter, the U.S. Commerce Department said GDP grew at an estimated pace of 2.9%, against expectations of 2.4%.10 The stronger-than-expected headline figure was, in part, due to a technical bounce in inventories, leaving the underlying consumption and investment trends more in line with the somewhat more tepid growth seen during the first half of 2016. Nevertheless, a rise in third-quarter GDP growth, coupled with ongoing improvement in the labor market and a modest increase in inflation expectations, has raised the odds of a December rate hike.11 Market-implied odds that the U.S. Fed will raise interest rates at its December meeting stood at 74% by week’s end, its highest level since immediately before the U.S. Fed’s December 2015 rate hike. Key factors influencing the direction of bond yields in the weeks ahead include any rhetoric coming out of next week’s Federal Open Market Committee policy-setting meeting, October’s payroll report and the result of the U.S. elections.
Chart of the week: Changing sentiment
- Across the spectrum, corporate credit has benefited this year from generally stable economic conditions in the United States and ongoing accommodative monetary policies both at home and abroad. Returns on high yield bonds and senior secured loans in particular have been propelled by a strong rebound in the commodity sector.
- With a year-to-date total return of approximately 8.25%, senior secured loans have generated a relatively solid performance thus far in 2016.2 Year-to-date total returns on senior secured loans have outpaced the S&P 500 (6.21%) while also besting returns on investment grade bonds and 2- and 10-year Treasury notes. Senior secured loans have underperformed high yield and 30-year Treasury bonds over the same time frame.12
- As the chart highlights, total returns on both senior secured loans and high yield bonds have outperformed all other major fixed income asset classes since the beginning of September, returning 1.61% and 1.47%, respectively.12 In fact, senior secured loans and high yield bonds are the only major fixed income asset classes that have generated positive total returns in that time frame. (Returns on 2-year Treasury notes have been roughly flat.)
- Since September 1, yields on 10-year Treasuries have risen approximately 28 basis points to 1.85%, while yields on 10-year German bunds have climbed roughly 23 basis points to 0.17%.5,6 Senior secured loans and high yield bonds have drawn significant interest within this environment, as investors have increasingly shown a preference for investments with very low or limited durations.
1 Bank of America Merrill Lynch U.S. Corporate Master Index.
2 Bank of America Merrill Lynch High Yield Master II Index.
3 Credit Suisse Leveraged Loan Index.
4 Thomson Reuters Lipper.
5 Federal Reserve Bank of St. Louis, http://bit.ly/2aAmG9p.
6 Bloomberg, http://bloom.bg/2ej0FZo.
7 Reuters, http://reut.rs/2dP44D8.
8 Federal Reserve Bank of St. Louis, http://bit.ly/2eZvbYa.
9 Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/DGS30.
10 U.S. Department of Commerce, http://bit.ly/1eZ44Hx.
11 Bloomberg, based on CME data.
12 Senior secured loans represented by the Credit Suisse Leveraged Loan Index; high yield bonds represented by the Bank of America Merrill Lynch High Yield U.S. Master II Index; investment grade bonds represented by the Bank of America Merrill Lynch U.S. Corporate Index.
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