High yield bonds, senior secured loans on track for another annual gain
Corporate credit prices ticked higher against the backdrop of a U.S. Federal Reserve rate hike, a weak core Consumer Price Index (CPI) report and progress on the Republican-led tax bill.1,2,3 High yield bonds generated a modest gain this week despite experiencing a somewhat sizeable outflow.4 High yield bond mutual funds reported a weekly outflow of approximately $922 million, which brings year-to-date outflows to approximately $19.7 billion.5 Nevertheless, high yield bonds are providing a year-to-date return of approximately 7.28% after generating a return of 17.49% in 2016.4 Year to date, lower rated bonds are leading the way, with CCC rated bonds generating returns of more than 9.92%.6 This compares to BB rated bonds and B rated bonds, which are returning 7.07% and 6.56%, respectively.7,8 While yields have widened since the 5.37% seen in late October, high yield bond yields currently sit well below the 6.17% seen at the outset of the year.9 Senior secured loans also registered modest gains this week, bringing year-to-date gains to 4.02%, putting the asset class on track to generate its eighth positive annual return over the past nine years. Similar to high yield bonds, lower rated credits have outperformed the broader senior secured loan index, with CCC rated loans providing returns of 7.06% so far in 2017.11 Against the backdrop of strong demand from both bank loan mutual funds and collateralized loan obligations, senior secured loans have also experienced some modest spread compression in 2017.5,12 After tightening to approximately 5.89% in early August, senior secured loan yields have since widened to 6.26%, slightly lower than they were at the outset of 2017.13
U.S. Treasury yields decline on muted inflation
U.S. Treasury yields declined across the curve after core U.S. CPI data came in softer than expected and the U.S. Federal Reserve’s dot plot held steady at three rate hikes in 2018.2,14 Headline CPI increased 0.4% month-over-month in November, boosted by higher energy prices.2 However, core CPI was far more modest, rising just 0.1% month-over-month and slowing to 1.7% year-over-year.2 The November CPI suggests inflation pressures remain muted and largely overshadowed any effect higher Producer Price Index (PPI) data, stronger U.S. retail sales figures and progress on a tax overhaul might have had on U.S. Treasury yields.15,16,3 Over the past two months, U.S. 10-year Treasury yields have been trading in a tight 20 basis point range, while the U.S. two-year Treasury yield has moved steadily higher in anticipation of this week’s rate hike.17,18 This combination has produced the flattest yield curve in over a decade.19 Beginning 2017 at approximately 1.22%, the U.S. two-year Treasury yield has since risen to 1.84%.18 Meanwhile, the yield on the U.S. 10-year Treasury note slipped to 2.37% this week, approximately 7 basis points below where it stood at the outset of 2017.17
U.S. Federal Reserve signals gradual approach to raising rates
With a December rate hike all but priced into the markets heading into this week’s FOMC policy meeting, the more interesting development was what the committee signaled about its policy outlook for 2018 and beyond.20 To that end, the Fed’s statement and economic projections skewed somewhat dovish, with officials making no significant changes to projections about the path of interest rates or inflation.14 Officials still expect to raise rates three times in 2018 and for core inflation to rise to just 1.9% by the end of next year despite expecting the economy to grow faster and for the labor market to tighten further.14 New projections show Fed officials expect the economy to grow at a rate of 2.5% this year and next, up from prior projections of 2.4% and 2.1%, respectively.14 While the statement yielded few surprises overall, one surprise was that two Fed officials voted against a December rate increase.1 This, combined with low inflation and modest wage growth, could support the case for sticking to a very gradual approach to raising rates in the months ahead.
Chart of the week: The Fed keeps moving though inflation remains below target
- In its final meeting of 2017, the U.S. Federal Reserve raised the target federal funds rate to a range of 1.25%–1.50%.1 It was the Fed’s fifth rate hike in this cycle and its third this year.21 While the Fed hike was largely expected, its economic projections were noteworthy in that the Fed substantially upgraded its estimate for economic growth in 2018.14
- Given their rosy growth outlook, policymakers kept their rate projections for next year unchanged. They still estimate that the FOMC will raise rates three times in 2018, to 2.1%.14
- Investors, however, seemed skeptical of the Fed’s current interest rate path as both the value of the U.S. dollar and the yield on the 10-year U.S. Treasury note declined after the Fed’s announcement.22 Much of the doubt can be traced back to the fact that inflation data remains muted.
- On the same day that the Fed raised rates, for example, the Bureau of Labor Statistics released Consumer Price Index (CPI) data for November. On a year-over-year basis, CPI showed a solid 2.2% gain.2 However, as the chart highlights, core CPI data, which excludes volatile food and energy prices, rose just 1.7% and declined from one month earlier.2
- Members of the FOMC have changed their tone on inflation recently, acknowledging that low inflation “could prove more persistent” than they originally anticipated.23 Indeed, as the Fed plots its way toward a normalized rate environment, it could likely remain bound by what have been persistently low inflation readings.
1 U.S. Federal Reserve, Fed Statement, http://bit.ly/2jUUe3n.
2 Bureau of Labor Statistics, CPI, http://bit.ly/2jKLr2f.
3 The Wall Street Journal, http://on.wsj.com/2Binx9Z.
4 ICE Bank of America Merrill Lynch U.S. High Yield Master II Index.
5 Thomson Reuters Lipper.
6ICE Bank of America Merrill Lynch U.S. High Yield CCC Rated & Lower Index.
7 ICE Bank of America Merrill Lynch U.S. High Yield BB Rated Index.
8 ICE Bank of America Merrill Lynch U.S. High Yield B Rated Index.
9 ICE Bank of America Merrill Lynch U.S. High Yield Master II Index (yield-to-worst).
10 Credit Suisse Leveraged Loan Index.
11 Credit Suisse Leveraged Loan Index (CCC rated component).
12 Thomson Reuters LPC.
13 Credit Suisse Leveraged Loan Index (yield to a three-year maturity).
14 U.S. Federal Reserve, FOMC projections, http://bit.ly/2Bh8q0L.
15 Bureau of Labor Statistics, PPI, http://bit.ly/2jfizlj.
16 U.S. Census Bureau, Retail Sales, http://bit.ly/Y4FaTF.
17 Federal Reserve Bank of St. Louis, U.S. 10-year Treasury yield, http://bit.ly/29ecBfp.
18 Federal Reserve Bank of St. Louis, U.S. 2-yr Treasury yield, http://bit.ly/2anGvQ0.
19 Federal Reserve Bank of St. Louis, 10-year/2-year Treasury spread, http://bit.ly/2oMWaP2.
20 Bloomberg, based on CME data.
21 U.S. Federal Reserve, http://bit.ly/29y0IjN.
22 The Wall Street Journal, http://on.wsj.com/2o1a94K.
23 U.S. Federal Reserve October-November minutes, http://bit.ly/2hVcZ95.
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