Corporate credit picked up where it left off 2016, with high yield bonds and senior secured loans strengthening this week on the back of rising U.S. equities, higher oil prices and ongoing inflows into both asset classes. In what was the asset class’s best annual performance since 2009, high yield bonds returned approximately 17.5% in 2016, led by a sharp rally in both the metals and mining and energy industries.1,2,3 Similarly, value-based areas of the high yield bond market led 2016’s rally after sharply lagging the broader benchmark in 2015. After returning -15.0% in 2015, CCC rated bonds provided gains of 36.5% in 2016 as investors exhibited a renewed appetite for risk in their ongoing search for yield.4 Senior secured loans followed a similar trajectory, with the asset class providing total returns of approximately 9.9% in 2016, with momentum building towards year-end amid rising Treasury yields and large flows into bank loan mutual funds.5 Following outflows of more than $45.5 billion across 2014 and 2015, bank loan mutual funds recorded inflows of $7.8 billion in 2016 as investors increasingly sought out investments whose values are less affected by rising interest rates.6
This week, the U.S. Federal Reserve offered another glimpse into its economic outlook when it released the minutes from its December 13–14 meeting.7 On balance, however, the minutes offered little new information to what its December statement and ensuing press conference provided.8 Generally, Fed officials judged it too early to determine whether the result of the U.S. presidential election, and potential for increased fiscal spending, had materially changed the U.S. economic outlook. Some officials saw the potential for stronger economic growth and further wage increases leading to inflationary pressures, while others noted that the strengthening of the U.S. dollar could continue to hold down inflation.7 Though citing “considerable uncertainty,” the minutes suggested the Fed would be sensitive to any “future fiscal and other economic policy initiatives.”7 Most notably, the minutes indicated that the Fed may also have little appetite for allowing the unemployment rate to drop much further. “Many participants judged that the risk of a sizable undershooting of the longer-run normal unemployment rate had increased somewhat and that the Committee might need to raise the federal funds rate more quickly than currently anticipated.”7
December’s nonfarm payrolls report was the highlight of a week of relatively strong U.S. economic data, with bond investors largely focusing on a notable rise in wage growth. Average hourly earnings increased by 10 cents, or 0.4%, in December, after declining 2 cents, or 0.1%, in November.9 This pushed the year-over-year increase to 2.9%, the largest annual gain since June 2009.10 While the unemployment rate rose slightly to 4.7% due to a rise in the labor force participation rate, the generally solid report reinforces the perception that overall labor market conditions remain solid and that the U.S. economy is now close to full employment.9 At 156,000, December’s rise in nonfarm payrolls slowed from November’s pace of 204,000.9 However, the gains were well above the 100,000 that U.S. Fed officials previously said the economy needs to generate in order to absorb new entrants into the labor force.11
Chart of the week: Duration and rising rates
- Interest rates experienced a significant and sustained climb in 2016. It was their largest rise since the “taper tantrum” of 2013 and followed several years of investors looking for signs of rising rates, only to see them continue their long-term decline.
- After reaching a post-Brexit low of just 1.37% in July 2016, the yield on the 10-year Treasury note began to slowly rise through much of the second half of the year before experiencing a sharp jump after the November 2016 elections. In mid-December, the yield on the 10-year Treasury note reached its highest point in more than two years.12 It ultimately settled down slightly from its peak to end the year at 2.45%, but still rose more than one percentage point from its July 2016 low.1
- Meanwhile, 3-month LIBOR closed the year at its highest point since 2009 and recently breached the 1.00% floor that is currently included in most senior secured loans.13
- Within this environment, duration proved to be an important driver of returns across the fixed income landscape. As the chart highlights, total returns on high yield bonds and senior secured loans far outpaced those of their longer-duration peers including investment grade bonds and longer-dated Treasuries.14
1 Bank of America Merrill Lynch U.S. High Yield Master II Index.
2 Bank of America Merrill Lynch U.S. High Yield Metals/Mining Index.
3 Bank of America Merrill Lynch U.S. High Yield Energy Index.
4 Bank of America Merrill Lynch U.S. High Yield CCC & Lower Rated Index.
5 Credit Suisse Leverage Loan Index.
6 Thomson Reuters Lipper.
7 U.S. Federal Reserve, http://bit.ly/2i0Hp7p.
8 U.S. Federal Reserve, http://bit.ly/2gJIC3Q.
9 U.S. Department of Labor, http://bit.ly/2iYbHWM.
10 Bloomberg, http://bloom.bg/2iLGwye.
11 The Wall Street Journal, http://on.wsj.com/2hYM0U9.
12 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
13 Federal Reserve Bank of St. Louis, http://bit.ly/2dn3Kt7.
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