Reaching for yield
Corporate credit was flat to modestly higher this week amid strong U.S economic data, an uneventful U.S. Federal Reserve meeting and ongoing inflows into the higher yielding corners of the market. High yield bond prices rose during the week ended February 2, adding to the gains of January, as inflows into high yield bond mutual funds reaccelerated.1 High yield bond yields remained near 10-month lows this week despite a slide in U.S. equities and overall higher new issuance volume.2 Following two straight weeks of outflows, inflows into high yield bond mutual funds turned positive this week. For context, inflows into high yield bond mutual funds now total more than $5.3 billion since the U.S. presidential election.3 Senior secured loans were modestly lower this week amid higher new issuance volume and an uptick in refinancing activity.4 As yields tighten across the corporate credit markets, companies are increasingly seeking to take advantage of strong market conditions to lower the rates paid on corporate loans. Through January, corporate issuers “repriced,” or lowered the interest rate on, more than $61 billion worth of senior secured loans.5 This repricing activity has acted to temper gains in recent weeks, with senior secured loans providing returns of 0.53% in January, a slight deceleration from the 1.15% achieved in December.4 By comparison, investment grade corporate bonds and U.S. 10-year Treasury bonds returned 0.41% and 0.04%, respectively, in January.6
Steady as she goes
As expected, this week’s Federal Open Market Committee meeting yielded little in the way of new messaging regarding the prospect of future rate hikes, reiterating that it remains on track to gradually raise short-term interest rates this year. With no press conference and no new “dot plot,” investors focused on the U.S. Fed’s description of the U.S. economy. To that end, the central bank described the near-term risks to its outlook as “roughly balanced,” suggesting it believes the U.S. economy continues to make progress.7 Investors also focused on the paragraph describing the outlook for the Fed’s reinvestment policy, as any shift could signal a change in the central bank’s plans to continue reinvesting proceeds of the maturing bonds on its balance sheet.7 While the Fed indicated no change to its current bond reinvestment policy in this week’s statement, the net effect of its current policy will be reduced stimulus over the longer-term. In a footnote to her January 19 speech, Fed Chair Yellen said that the average maturity of the Fed’s bond portfolio is declining. This process alone, she observed, would have the same impact on 10-year Treasury yields as two separate 25 basis point rate hikes over the course of 2017.8
A modest raise
Although solid, investors viewed Friday’s nonfarm payrolls report as reducing the probability of a near-term rate hike. While the U.S. economy added a larger-than-expected 227,000 jobs in January, investors focused on what was only a modest rise in average hourly earnings.9 Wages rose 3 cents, or 0.1%, from December against expectations of 0.3%, suggesting that the labor market may have room to tighten further.10 The jobs report capped off another week of generally solid U.S. economic data, with a rise in the Institute for Supply Management’s manufacturing index suggesting a healthier manufacturing sector and the personal-consumption expenditures price index rising 1.6% in December.11,12 Nevertheless, investors trimmed expectations of either a March or June rate hike. As of Friday, investors placed just a 24% probability of a rate increase in March, down from 32% earlier in the week, and a 68% probability of a rate increase in June, down from 71% earlier in the week.13
Chart of the week: Middle market premium moves higher
- With more-limited sources of financing, middle market companies often must pay higher interest rates than large corporate borrowers of similar credit quality.
- This “middle market premium” averaged approximately 120 basis points through 2016, but it declined to as little as 74 basis points in September 2016 as yields across the credit spectrum fell.14
- Since its September trough, new issue yields on large corporate loans have continued to decline while those on middle market loans have increased. As of January 2017, the yield spread between the two reached 214 basis points, or almost 1.00% above its 2016 average.14
- A decline in yields across the broadly syndicated market can explain part of this divergence. However, a wave of repricing activity, which has intensified since late 2016, has helped exaggerate the spread between large corporate and middle market loans.
- In fact, approximately $61 billion in loan repricing activity took place in January 2017.5 This was the second-highest amount on record, behind only the $67 billion in loans repriced in February 2013.5
1 Bank of America Merrill Lynch High Yield Master II Index.
2 Bank of America Merrill Lynch High Yield Master II Index (yield-to-worst).
3 Thomson Reuters Lipper.
4 Credit Suisse Leveraged Loan Index.
5 J.P. Morgan High-Yield and Leveraged Loan Morning Intelligence, January 30, 2017.
6 Bank of America Merrill Lynch U.S. Corporate Master Index.
7 U.S. Federal Reserve, http://bit.ly/2kWrohs.
8 U.S. Federal Reserve, http://bit.ly/2ka64ri.
9 U.S. Department of Labor, http://bit.ly/2iYbHWM.
10 The Wall Street Journal, http://on.wsj.com/2jKOsyG.
11 Institute for Supply Management, http://bit.ly/2dBZnbi.
12 U.S. Department of Commerce, http://bit.ly/1cR0IcA.
13 Bloomberg, based on CME data.
14 S&P Global Market Intelligence.
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