Yield of dreams
The corporate credit markets remained stable this shortened holiday week, with both high yield bonds and senior secured loans registering modest gains.1,2 Notably, bank loan mutual funds reported a small inflow for the week ended July 5, snapping two consecutive weekly outflows for a total of $414 million over that period.3 The reversal comes amid a rise in U.S. Treasury yields, which has redirected some investor attention back to the risk of rising long-term interest rates.4 Year to date, investors have put nearly $17 billion into bank loan mutual funds in search of investments that may be less impacted by U.S. central bank policy normalization.3 This compares to the more than $10 billion in net outflows high yield bond mutual funds have endured so far in 2017.3 Nevertheless, high yield bonds are providing a year-to-date return of approximately 4.9%, outperforming both investment grade corporate bonds and senior secured loans as investors have shown a willingness to migrate down the ratings spectrum in their ongoing search for yield.1,5,2 Although underperforming the broader index in June, CCC rated bonds outperformed both BB and B rated bonds through the first half of 2017.1,6,7,8 At week’s end, CCC rated bonds were yielding approximately 10.9%. This compares to the approximately 4.3% and 5.9%, respectively, that BB rated and B rated bonds were yielding.9,10,11
Counting the minutes
Bond investors have focused on global central bank signals in recent weeks amid an emerging narrative that the European Central Bank is slowly moving toward reducing stimulus measures.12 Against the backdrop of rising German government bond yields, investors were looking to minutes from the U.S. Federal Reserve’s June meeting for signals on the timing of when the U.S. central bank may begin shrinking its balance sheet.13 Although markets currently anticipate a September start date, the minutes suggested no consensus from Fed officials on the timing of when balance sheet runoff should begin.14 Some officials argued that the central bank should start the process “within a couple of months,” while others suggested that any “near-term change to reinvestment policy could be misinterpreted as signifying that the Committee had shifted toward a less gradual approach to overall policy normalization.”13 The Fed officials’ discussion around inflation was also notable in that, although there was general agreement that the recent decline in inflation is probably transitory, “several participants expressed concern that progress toward the Committee’s two percent longer-run inflation objective might have slowed and that the recent softness in inflation might persist.”13
A solid nonfarm payrolls report capped off the week, with a strong headline jobs growth figure tempered by a somewhat disappointing wage growth figure.15 Nonfarm payrolls rose by 222,000 in June, against consensus expectations of 174,000 jobs, while April and May’s figures were revised higher by a combined 47,000.16 While the higher-than-expected headline figure eases any concerns about a slowdown in jobs growth, investors zeroed in on the lower-than-expected rise in average hourly earnings.16 At 0.2%, wage growth was disappointing again in June and serves to strengthen the narrative of a U.S. central bank unlikely to rush to raise interest rates.17 While the muted reaction at the front end of the U.S. Treasury yield curve to Friday’s jobs report suggests investors don’t expect a change in the timing of the Fed’s next interest rate hike, a rise in longer-term yields suggests growing confidence in the economic outlook.18,19 After declining to a nine-month low in June, the U.S. Treasury yield curve has risen more 20 basis points over the past two weeks, with the two-year/10-year spread closing in on 1.0% for the first time since mid-May.20
Chart of the week: Duration has risen for investment grade bonds and declined for high yield bonds
- According to the minutes of the Fed’s June meeting released this week, the Federal Reserve has reached a consensus on how it will begin the process of reducing the size of its balance sheet. Although participants “expressed a range of views about the appropriate timing” to begin the process, markets appear to be prepared for an announcement at the Fed’s September meeting.13
- In an attempt to avoid any potential taper tantrum-like market reactions, policy makers have insisted that the balance sheet reduction process, once it begins, will be uneventful. In May, Patrick Harker, President of the Federal Reserve Bank of Philadelphia, referred to it as “the policy equivalent of watching paint dry.”21
- The combination of additional rate hikes this year and next, along with balance sheet reductions, seems likely to tighten financial conditions and could cause long-term rates to rise.
- Portfolio duration, which measures the potential impact a change in interest rates will have on a bond’s price, may become a renewed consideration for fixed income investors as we potentially enter a new phase of Fed tightening.
- To this end, it is important to note the diverging duration paths that investment grade bonds and high yield bonds have taken over the past approximately 18 months. For example, investment grade bonds’ duration has slowly risen since the beginning of 2016, from approximately 5.8 to 6.2 years.22 During the same time frame, high yield bonds’ duration has gradually decreased, from approximately 4.2 years to 3.7 years.22
1 Bank of America Merrill Lynch U.S. High Yield Master II Index.
2 Credit Suisse Leveraged Loan Index.
3 Thomson Reuters Lipper.
4 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
5 Bank of America Merrill Lynch U.S. Corporate Master Index.
6 Bank of America Merrill Lynch U.S. CCC rated and Lower Index.
7 Bank of America Merrill Lynch U.S. BB rated Index.
8 Bank of America Merrill Lynch U.S. B rated Index.
9 Bank of America Merrill Lynch U.S. CCC rated and Lower Index (yield-to-worst).
10 Bank of America Merrill Lynch U.S. BB rated Index (yield-to-worst).
11 Bank of America Merrill Lynch U.S. B rated Index (yield-to-worst).
12 Bloomberg, https://bloom.bg/2sTdvE8.
13 U.S. Federal Reserve, http://bit.ly/2tN37BN.
14 MarketWatch, http://on.mktw.net/2tN631h.
15 U.S. Department of Labor, http://bit.ly/2iYbHWM.
16 The Wall Street Journal, http://on.wsj.com/2uSmlDw.
17 The Wall Street Journal, http://on.wsj.com/2tQBKr7.
18 Federal Reserve Bank of St. Louis, http://bit.ly/2anGvQ0.
19 Federal Reserve Bank of St. Louis, http://bit.ly/29ecFfc.
20 Federal Reserve Bank of St. Louis, http://bit.ly/2oMWaP2.
21 “Economic Outlook: The Labor Market, Rates, and the Balance Sheet,” May 23, 2017.
22 Bloomberg. As of June 30, 2017.
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