Fixed-income performance in the fourth quarter was mixed, as the shape of the yield curve compressed to its flattest level since before the 2008-09 global financial crisis and corporate credit spreads diverged between the investment-grade and high-yield sectors. Similarly, year-to-date performance was significantly affected by the flattening curve, as the performance of short-duration indexes was muted, whereas long-duration indexes outperformed. While there were a few spikes in volatility earlier in the year, volatility was subdued in the fourth quarter and ended the year near historical lows.
During the fourth quarter, the yield on the 2-year Treasury bond rose 40 basis points and has risen 69 basis points since the end of 2016. The yield on the 2-year has risen even more thus far this year and is trading at its highest yield since October 2008. While short-term rates have been rising quickly, the yield on the 30-year Treasury bond declined 12 basis points in the fourth quarter and dropped 25 basis points over the course of the year, trading in its lowest quartile since the global financial credit crisis. As the yield on short-term bonds rose and the yield on long-term bonds fell, the spread between the 2-year Treasury and the 10-year Treasury compressed to 53 basis points at year-end, its narrowest level since before the global credit crisis.
In the corporate bond market, credit spreads in the investment-grade market have tightened this past quarter, whereas credit spreads in the high-yield market have widened slightly. While there was a slight divergence this quarter, year-to-date corporate credit spreads have tightened across both the investment-grade and high-yield sectors. Corporate credit markets have been buoyed by a combination of generally improving credit metrics, fewer debt-funded mergers and acquisitions or shareholder-enhancement programs, and the market’s expectation that revisions to tax and regulatory policies will bolster corporate credit strength by invigorating economic growth and boosting earnings.
The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, eked out a gain of 0.40% in the fourth quarter, as declining long-term interest rates provided enough price appreciation to offset the pressure from rising short-term rates.
Underlying the Core Bond Index, the Short-Term Core Bond Index registered a loss of 0.24% as short-term rates rose to their highest levels in over a decade. The Intermediate-Term Core Bond Index was nearly unchanged, registering a loss of 0.04% as rising rates more than offset the yield carry from the underlying bonds in the index. The outperformer this past quarter was the Long-Term Core Bond Index, which rose 1.93%. In the Treasury market, the Morningstar US Government Bond Index registered a gain of 0.10%, as the negative impact of rising short-term and intermediate-term rates on bond prices offset much of the yield carry for the quarter. Similarly, the Agency Bond Index eked out a 0.02% return. After lagging much of the rest of the fixed-income universe in the first half of the year, Treasury Inflation-Protected Securities performed well in the fourth quarter. The Morningstar TIPS Index rose 1.31% as inflation expectations held steady.
In the corporate bond market, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) rose 1.10%, supported by a modest tightening in corporate credit spreads and a slightly longer duration than other indexes. In the high-yield market, the BofA Merrill Lynch High Yield Master Index rose 0.39%, as the higher yield carry of the index was offset by a slight widening of corporate credit spreads in the junk bond market and the increase in medium-term interest rates. In Europe, tightening credit spreads and lower interest rates helped bolster the Morningstar Eurobond Corporate Bond Index, which rose 0.49%.
Following very strong returns in the third quarter, emerging-markets fixed-income indexes were unable to repeat the performance. For the fourth quarter, the Morningstar Emerging Markets Composite Bond Index rose 0.41%, as the underlying Morningstar Emerging Markets Sovereign Bond Index rose 0.36% and the Morningstar Emerging Markets Corporate Bond Index rose 0.51%.
Weekly Corporate Bond Market Highlights
The corporate bond market began to wake up after the typical seasonal holiday-indexed slowdown. The window to the new issue market reopened, and secondary market trading emerged from hibernation. However, reinvigorated activity did not result in a revival in volatility, which remained muted, and corporate credit spreads tightened. In fact, volatility in the equity markets reached all-time lows during intraday trading. For example, the CBOE Volatility Index declined to below 9 for the first time. Over time, market volatility and corporate credit spreads have been highly correlated. Based on the average spread of the Morningstar Corporate Bond Index since 1990, the VIX and investment-grade credit spreads have an R-squared of approximately 85%.
The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 1 basis point over the course of last week, ending at +95. The BofA Merrill Lynch High Yield Master Index tightened 22 basis points to end the week at +336.
The yield curve continued its flattening trend last week. The yield on the 2-year and 5-year Treasury bonds rose 8 basis points and 1 basis point, respectively, to 1.96% and 2.29%. At these levels, the yield on the 2-year Treasury bond is its highest since the global credit crisis, and the yield on the 5-year Treasury bond is its highest since 2011. In the longer end of the curve, the yield on the 10-year and 30-year Treasury bonds rose 6 basis points and 7 basis points, respectively, to 2.47% and 2.81%. The yield curve has been on a multiyear flattening trend since the Federal Reserve began to raise short-term rates in its pursuit of normalizing monetary policy. Currently, as measured by the spread between the 2-year and 10-year bonds, the yield curve is at its flattest level since before the global financial crisis.
The yield curve has flattened as short-term rates have risen in conjunction with the increases in the federal-funds rate as the Fed normalizes monetary policy, yet long-term rates have fallen as inflation and inflation expectations remain muted. Currently, according to CME Group’s FedWatch Tool, the market is pricing in a 68% probability that the Fed will raise the federal-funds rate at its March meeting and a 79% probability that the federal-funds rate at the end of 2018 will be greater than 1.75%. The Federal Reserve released its updated projections following its December 2017 meeting, which includes forecasts by the board members for the federal-funds rate. The average projected federal-funds rate from the board members is 2%, 2.70%, and 3%, for the years ended 2018, 2019, and 2020.
While the market prices in additional hikes in short-term rates, inflation expectations remain muted. For example, the 5-year, 5-year forward inflation expectation rate (market0derived expectation for average inflation for five years, beginning five years from today) is at 2% and has traded within 20 basis points of 2% since October 2016.
Weekly High-Yield Fund Flows End Year on Positive Note,
but Annual Redemptions Outpaced Inflows
Fund flows in the high-yield asset class ended the year on a positive note with slightly over $1 billion of inflows for the week ended Jan. 3. The total consisted of $0.4 billion of inflows in open-end funds and $0.7 billion of new unit creation in high-yield exchange-traded funds. However, for the year, the high-yield asset class experienced total net redemptions of $10.6 billion, consisting of $14.8 billion of redemptions in open-end mutual funds offset by $4.1 billion of new unit creation in ETFs.