Corporate credit prices were generally stronger this week against the backdrop of rising U.S. equities, higher oil prices and a well-telegraphed U.S. Federal Reserve decision to begin balance sheet normalization in October.1,2,3. High yield bonds returned approximately 0.21% this week and are now providing a gain of 0.59% in September.4 This follows the modest loss generated in August and puts the asset class on track for its eighth monthly gain in 10 months.4 High yield energy bonds have been an outperformer in September, tracking an improved backdrop for oil prices.5 High yield energy bonds are providing returns of approximately 2.42% in September and approximately 4.53% in 2017.6 Also outperforming in September are CCC rated bonds.7 After underperforming their higher rated peers in August, CCC rated bonds (1.04%) are outperforming both B rated (0.46%) and BB rated (0.55%) bonds in September as investors appear to once again be willing to move down the capital structure in search of yield.7,8,9 Senior secured loan prices also improved this week, providing another modest weekly gain for the asset class.10 Month to date, senior secured loans are providing returns of approximately 0.29%, on track for their 17th monthly gain in 19 months.10 Having underperformed in 2017, senior secured loans currently offer a yield premium to high yield bonds. For context, senior secured loans currently yield approximately 6.14%, whereas high yield bonds currently yield approximately 5.51%.11,12
The long run
Ahead of this week’s FOMC policy meeting, the question for investors was not whether the U.S. Fed would begin to unwind its $4.5 trillion balance sheet, but rather what signals it would send about the likely path of interest rates going forward. Aside from acknowledging the recent hurricanes, indicating that it doesn’t expect economic activity to be impacted over the medium term, the Fed’s post-meeting statement showed few changes from the one prior.3,13 As expected, the Fed announced it would initiate its plan to begin unwinding its balance sheet and signaled its intention to raise short-term interest rates again in December.14 However, while new economic projections kept alive the possibility of another rate increase this year, they showed lower expectations for rates over the longer run.14 The median projection for the longer-run level of rates was lowered to 2.75% from 3.0% in June.14 Fed officials also revised down their projection of core inflation to 1.5% for the end of 2017 from their previous projections of 1.7%.14
While the message from the Fed’s updated economic projections was somewhat mixed, bond investors focused more on the possibility of a near-term rate hike than the more dovish long-run interest rate projections.15 The yield on the U.S. two-year Treasury note was notably higher, rising briefly to its highest level since November 2008, while the yield on the U.S. 10-year Treasury note hit a two-month high.16,17 Meanwhile, Fed funds futures now suggest a 65% probability of a December rate hike, up from less than a 50% probability a week ago.18 While geopolitical tensions had eased recently, and took a back seat to central bank policy through the better part of the week, bond investors’ attention had returned to North Korea by week’s end. U.S. government bond yields declined across the curve Friday morning after North Korea’s foreign minister suggested the country might test a hydrogen bomb, but remained well off recent lows.19 Since declining to a year-to-date low of 2.04% earlier this month, the yield on the U.S. 10-year Treasury note has since climbed more than 0.20% to 2.25%.17
Chart of the week: Lower for longer… longer
- At its meeting this week, the FOMC largely remained on course with the guidance it had provided earlier this year. As expected, the FOMC announced it will begin the process of reducing its balance sheet in October 2017.3 Also as expected, the FOMC kept the target federal funds rate unchanged, yet hinted that it may raise rates again at its December meeting.3
- Despite the Fed largely following through on earlier guidance, markets interpreted the policymakers’ statement and Chair Yellen’s subsequent press conference as mildly hawkish as investors continue to believe that rates will remain well under the Fed’s projections.20
- Fed funds futures for the December meeting moved sharply higher – now pricing in an approximately 65% chance that the FOMC will raise rates at its December meeting, up from less than 50% probability a week ago.18 Stocks also moved lower immediately after the Fed’s statement was issued, while the yield on the 10-year U.S. Treasury note rose approximately 5 basis points before settling somewhat in the afternoon.21,17
- Despite the market’s apparent surprise, very little changed in the Fed’s Summary of Economic Projections from June.14 In fact, perhaps the most notable change from June was a dovish one. The Fed now anticipates the longer-run federal funds rate to rise to just 2.75%, down from June’s 3.0% projection.14 Yellen noted in her accompanying press conference that the committee anticipates that interest rates’ longer-run neutral level is “likely to remain below levels that prevailed in previous decades.”22
1 Federal Reserve Bank of St. Louis, http://bit.ly/2d3pN5b.
2 Federal Reserve Bank of St. Louis, http://bit.ly/292Tgue.
3 U.S. Federal Reserve,http://bit.ly/2xiQrVP.
4 Bank of America Merrill Lynch U.S. High Yield Master II Index.
5 International Energy Agency,http://bit.ly/2yuMRoZ.
6 Bank of America U.S. High Yield Energy Index.
7 Bank of America U.S. High Yield CCC Rated & Lower Index.
8 Bank of America U.S. High Yield B Rated Index.
9 Bank of America U.S. High Yield BB Rated Index.
10 Credit Suisse Leveraged Loan Index.
11 Credit Suisse Leveraged Loan Index (yield to a three-year takeout).
12 Bank of America Merrill Lynch U.S. High Yield Master II Index (yield-to-worst).
13 U.S. Federal Reserve, http://bit.ly/2s5LDj5
14 U.S. Federal Reserve, http://bit.ly/2fjuEX3.
15 The Wall Street Journal, http://on.wsj.com/2hkuaAc.
16 Federal Reserve Bank of St. Louis, http://bit.ly/2anGvQ0.
17 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
18 Bloomberg, based on CME data.
19 CNN, http://cnn.it/2xjjgkD.
20 Bloomberg, market-implied Fed funds target rate.
21 Federal Reserve Bank of St. Louis, http://bit.ly/2d3pN5b.
22 U.S. Federal Reserve, http://bit.ly/2xkqFjM.
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