Credit prices rebound following bumpy start to the week
After a bumpy start to the week, corporate credit prices rebounded to end the week relatively unchanged amid improved investor sentiment toward week’s end.1,2 Declining throughout the first part of the week, high yield bond prices rallied sharply Thursday as U.S. equity prices improved.1,3 For the week ended November 16, the high yield bond asset class returned approximately -0.02% despite enduring a large weekly outflow.1,4 High yield bond mutual funds reported an outflow of approximately $4.4 billion for the week ended November 15, the largest weekly outflow since the week of March 15 and the fourth largest weekly outflow on record.4 Month to date, high yield bonds are providing returns of approximately -0.83%, which is the largest monthly setback for the asset class since January 2016.1 Month-to-date declines have been largely driven by the telecommunications (-2.94%), consumer products (-2.22%), broadcasting (-1.49%), healthcare (-1.24%) and retail (-1.15%) sectors.5,6,7,8,9 Senior secured loans experienced moderate volatility this week as bank loan mutual funds recorded a weekly outflow of $530 million.4 Declining modestly, senior secured loan prices firmed toward week’s end alongside the rise in high yield bond prices.2 Senior secured loans have generated month-to-date returns of approximately -0.14%, the largest setback for the asset class since February 2016.2 Following this month’s modest declines, high yield bonds and senior secured loans are now providing returns of approximately 6.57% and 3.57%, respectively, in 2017.1,2
Energy credit in focus as oil prices slip
Oil was once again in focus this week as investors largely looked past a decline in output by members of the Organization of the Petroleum Exporting Countries (OPEC) and focused on an increase in U.S. crude stockpiles.10,11 While OPEC oil production declined by 0.46% to approximately 32.59 million barrels per day in October, a 1.9-million-barrel rise in U.S. oil inventories and signs of rising U.S. output helped oil to its first week-over-week decline in six weeks.10, 11,12 Against this backdrop, high yield energy bonds and energy senior secured loans saw modest declines, and are now providing returns of -0.23% and -0.61%, respectively, in November.13,14 For 2017, high yield energy bonds and senior secured loans have returned approximately 6.16% and 4.82%, respectively.13,14 For added perspective, the Alerian MLP Index and S&P 500 Energy Index have returned -11.91% and -8.44%, respectively, in 2017 and are generating month-to-date returns of approximately -2.62% and -1.29%, respectively.15,16
U.S. Treasury curve flattens following CPI data
Highlights of this week’s economic calendar included October’s U.S. retail sales and Consumer Price Index (CPI) reports, with bond investors looking to this week’s inflation data for further signals about the future path of short-term interest rates.17 Headline CPI increased a modest 0.1% in October, while core CPI rose 0.2% month-over-month and 1.8% year-over-year, suggesting inflation is gaining momentum only gradually.18 Although a December rate hike is almost fully priced into the market, the latest CPI data will likely play a role in the timing and number of rate increases in 2018.19 While the short-end of the U.S. Treasury yield curve rose this week, low inflation continues to hold down the longer-end of the curve.20,21 The yield differential between the U.S. two-year Treasury and 10-year Treasury Notes now stands at approximately 63 basis points, marking the flattest yield curve in more than 10 years.22 While U.S. Federal Reserve officials have maintained the view that three more interest rate increases in 2018 remains appropriate, some officials express their concern about persistently soft inflation.23 “Many economists subscribe to the view that this latest drop in core inflation simply reflects temporary factors,” said Federal Reserve Bank of Chicago President Charles Evans earlier this week. But “with each low monthly reading, it gets harder and harder for me to feel comfortable with the idea that the step-down last spring was simply transitory.”24
Chart of the week: Return expectations for traditional 60/40 portfolios decline
- Investors in traditional diversified portfolios consisting of 60% U.S. stocks and 40% U.S. bonds have been well rewarded over the past decade. These portfolios have produced real (net of inflation) average annual returns of approximately 9.2% and 4.5%, respectively, over the 5-year and 10-year periods ended October 31, 2017.25
- Through most of the past decade, domestic equity and fixed income assets have benefited from a combination of a healthy corporate profit landscape, slow-but-steady economic growth, low inflation and ultra-low interest rates.
- However, Research Affiliates estimates that generating real returns for a traditional 60/40 portfolio could be significantly more challenging in the coming decade. According to its most recent estimate, a 60/40 portfolio could produce real returns of less than 1% in the next 10 years.25
- In fact, the authors of a November 2017 Research Affiliates article, Building Portfolios: Diversification without the Heartburn, liken buying U.S. equities at today’s high valuations to riding the “buy low, sell high” wave in the wrong direction.26 The firm estimates that real returns across all domestic asset classes, except for U.S. commercial real estate, could be notably lower in the next 10 years than they were in the past 10.25
- Research Affiliates’ estimates generally match the conclusions the Federal Reserve Bank of San Francisco reached in a recent Economic Letter.27 The letter notes that today’s cyclically adjusted price-earnings ratio, or CAPE ratio, is likely to decline in the coming years, which “would imply lower returns on stocks relative to those enjoyed in recent years.”27
1 ICE Bank of America Merrill Lynch U.S. High Yield Master II Index.
2 Credit Suisse Leveraged Loan Index.
3 Federal Reserve Bank of St. Louis, S&P 500 Index, http://bit.ly/2d3pN5b.
4 Thomson Reuters Lipper.
5 ICE Bank of America Merrill Lynch U.S. High Yield Telecommunications Index.
6 ICE Bank of America Merrill Lynch U.S. High Yield Consumer Products Index.
7 ICE Bank of America Merrill Lynch U.S. High Yield Broadcasting Index.
8 ICE Bank of America Merrill Lynch U.S. High Yield Healthcare Index.
9 ICE Bank of America Merrill Lynch U.S. High Yield Super Retail Index.
10 OPEC Monthly Oil Market Report – November 2017, page 56, http://bit.ly/2iS1Z8W.
11 U.S. Energy Information Administration, http://bit.ly/1V2gPZQ.
12 Federal Reserve Bank of St. Louis, Crude Oil Prices, http://bit.ly/292Tgue.
13 ICE Bank of America Merrill Lynch U.S. High Yield Energy Index.
14 Credit Suisse Leveraged Loan Index (energy component).
15 Alerian, http://bit.ly/2yKWiRz.
16 Standard & Poor’s, http://bit.ly/2ydsLD0.
17 Econoday, http://bit.ly/1iJOdAP.
18 Bureau of Labor Statistics, http://bit.ly/2k22igk.
19 Bloomberg, based on CME Fed-fund futures data.
20 Federal Reserve Bank of St. Louis, 2-Year Treasury constant maturity rate, http://bit.ly/2anGvQ0.
21 Federal Reserve Bank of St. Louis, 10-Year Treasury constant maturity rate, http://bit.ly/29ecBfp.
22 Federal Reserve Bank of St. Louis, 10-Year minus 2-Year treasury constant maturity, http://bit.ly/2oMWaP2.
23 Reuters, http://reut.rs/2AVzpM5.
24 Federal Reserve Bank of Chicago, http://bit.ly/2j5tNqq.
25 Research Affiliates Asset Allocation Interactive as of October 31, 2017. Latest data available, http://bit.ly/2zp3V0t.
26 Research Affiliates, http://bit.ly/2iokPVR.
27 Federal Reserve Bank of San Francisco, http://bit.ly/2yR40ZN.
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