Reflation trade
Corporate credit markets continued to feel the effects of rising U.S. Treasury yields. High yield bonds and senior secured loans rose during the week ended December 1 on the back of higher U.S. equities and surging oil prices, while investment grade corporate bonds trended lower as U.S. 10-year government bonds capped their worst month in seven years.1,2 High yield bond returns were modestly positive this week, but remained in the red for the month of November, marking the first negative monthly return for high yield bonds since January.3 This modest decline brings year-to-date returns to 15.2% in what has been a stark turnaround for an asset class that returned -4.6% in 2015.3 High yield bond mutual funds saw another weekly inflow, pulling in approximately $940 million over the past two weeks, following a string of six consecutive weekly outflows totaling nearly $7.5 billion.4 Senior secured loan prices continued to trend higher in the week ended December 1 and ended the month solidly in positive territory.5 In recent weeks, senior secured loans have benefited from rising U.S. equities, upbeat U.S. economic data and the reflation trade that has been driving markets since the U.S. presidential election. In November, senior secured loans returned 0.32%, outperforming high yield bonds (-0.39%), investment grade corporate bonds (-2.7%) and 10-year U.S. Treasury notes (-4.7%), putting the asset class on track for its best annual performance since 2012.1,2,3,5

Output cut
The deal to cut production by OPEC provided an immediate boost to oil prices, with the U.S. crude benchmark rising over 13% after the agreement was announced.6 High yield energy bonds and energy senior secured loans responded to the surge in oil prices by rising approximately 1.7% and 1.5%, respectively, in the week ended December 1.7,8 Earlier in the week, OPEC agreed to cut oil production by 1.2 million barrels per day from the current 33.6 million barrels and said it expects producers outside the bloc to join with additional cuts totaling 600,000 barrels per day.9 The agreement, representing approximately 1% of total global output, marks the first time the group has agreed to cut output since 2008 and is a stark reversal from November 2014 when the group voted against cutting production in an effort to boost market share. Throughout 2016, rising oil prices have remained a key driver of returns as the energy sector has continued to outperform. Year to date, high yield energy bonds and energy senior secured loans are providing returns of approximately 34.9% and 30.1%, respectively.7,8 For context, high yield energy bonds and energy senior secured loans returned -23.6% and -27.1%, respectively, in 2015.7,8

Continued progress
Another week of solid U.S. economic data fueled a further decline in U.S. government bond prices, with the yield on the U.S. 10-year Treasury note briefly rising to its highest level since July 2015.10 Capping off a week that saw a solid U.S. manufacturing release, a jump in consumer confidence and an upward revision to third-quarter GDP growth, we believe Friday’s nonfarm payrolls report should further boost optimism about the U.S. growth outlook.11,12,13 At 178,000, November’s jobs growth largely met expectations and continues a string of strong labor market reports, with the unemployment figure having now declined to its lowest level in nine years.14 Beneath the strong headline figure, however, was a decline in labor force participation and a 0.1% month-over-month decline in average hourly earnings.14 Taken together, this week’s economic data is suggestive of the “further evidence of continued progress” that the U.S. Federal Reserve was seeking at its November meeting, and more than likely clears the bar for a December rate hike.15

Chart of the week: Rising rates and returns

  • Yields on 10-year Treasury notes resumed their climb this week, touching their highest point of the year, as investors continued their recent shift toward equities. The week’s activity was largely driven by strong economic releases as well as a surge in oil prices following OPEC’s agreement to cut oil output.16
  • The week’s interest rate move follows a strong surge just after the U.S. presidential election as investors began to prepare for an anticipated environment of higher economic growth and inflation accompanied by a more active Federal Reserve.10
  • Even before the November increase, however, Treasury yields had been slowly climbing since early July when they reached a post-Brexit low. In fact, yields on both 10-year Treasury notes and 30-year Treasury bonds have risen more than 1.00% since July 8.10,17
  • In that same time frame, total returns on a range of income-oriented investments have largely turned negative. As the chart highlights, total returns on 30-year Treasury bonds are down more than 17% while real estate investment trusts and investment grade bonds are down approximately 9% and 3%, respectively.16
  • Alternatively, total returns on high yield bonds, which tend to be less sensitive to interest rate movements, have risen nearly 4.5% since July 8 while senior secured loans, whose interest rates float based on changes in the London Interbank Offered Rate (LIBOR), are up approximately 4.0% since July 8.2,5 At 5.30%, large-cap stocks experienced the greatest gains of the asset classes presented.18

1 Bank of America Merrill Lynch U.S. Corporate Master Index.
2 Bank of America Merrill Lynch U.S. 10-year Treasury Index.
3 Bank of America Merrill Lynch High Yield Master II Index.
4 Thomson Reuters Lipper.
5 Credit Suisse Leveraged Loan Index.
6 Federal Reserve Bank of St. Louis,
7 Bank of America Merrill Lynch High Yield Energy Index.
8 Credit Suisse Leveraged Loan Index (energy component).
9 Reuters,
10 Federal Reserve Bank of St. Louis,
11 Institute for Supply Management,
12 The Conference Board,
13 U.S. Department of Commerce,
14 U.S. Department of Labor,
15 U.S. Federal Reserve,
16 Bloomberg.
17 Federal Reserve Bank of St. Louis,
18 Federal Reserve Bank of St. Louis,

The Alternative Thinking Week in Review market commentary and any accompanying data (“Market Commentary”) is for informational purposes only and shall not be considered an investment recommendation or promotion of FS Investments or any FS Investments fund. The Market Commentary is subject to change at any time based on market or other conditions, and FS Investments and FS Investment Solutions, LLC disclaim any responsibility to update such Market Commentary. The Market Commentary should not be relied on as investment advice, and because investment decisions for the FS Investments funds are based on numerous factors, may not be relied on as an indication of the investment intent of any FS Investments fund. None of FS Investments, its funds, FS Investment Solutions, LLC or their respective affiliates can be held responsible for any direct or incidental loss incurred as a result of any reliance on the Market Commentary or other opinions expressed therein. Any discussion of past performance should not be used as an indicator of future results.