Second-Quarter Corporate Bond Market Review
Although short-term interest rates rose in the second quarter as the Federal Reserve increased the federal funds rate, fixed-income indexes generally posted solid returns as long-term interest rates declined. The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose 1.53% in the second quarter. The return was generated by a combination of the yield carry on the underlying securities and the positive impact that lower long-term interest rates and tighter credit spreads have on bond prices. The Short Term Core Bond Index rose only 0.46% as rising short-term interest rates pressured returns, whereas the Intermediate Core Bond Index and the Long-Term Core Bond Index rose 1.10% and 3.55%, respectively, benefiting from declining long-term interest rates. Representative of the Treasury market, the Morningstar US Government Bond index rose 1.23%. The laggard this quarter was the Morningstar TIPS Index, which declined 0.43% as inflation expectations sank along with the price of oil. In the corporate bond market, the Morningstar Corporate Bond Index rose 2.49%, bolstered by a decrease in long-term interest rates and tightening credit spreads. Over the course of the second quarter, the average corporate credit spread of the Morningstar Corporate Bond Index tightened 11 basis points to +112. At its current level, the average credit spread of our corporate bond index is trading much tighter than its long-term historical average of +167. As an indication of how tight corporate credit spreads have become compared with their historical averages, since the beginning of 2000, the average spread of the Morningstar Corporate Bond Index has registered below the current level only 23% of the time. Not only are credit spreads tighter now than in much of the recent past, but the average credit quality of the Morningstar Corporate Bond Index is lower than it has been much of the time. Currently, the average credit quality of the Morningstar Corporate Bond Index is A-, whereas since 2000, the average credit quality has been either closer to or at single A for much of the time. While corporate bonds performed well in the United States, the Morningstar Eurobond Corporate Index rose only 0.16%. The average corporate credit spread in our Eurobond Corporate Index tightened 14 basis points this past quarter to an average spread of +94 basis points, yet the benefit of tighter corporate credit spreads was offset by the increase in the yield of underlying sovereign bonds. Interest rates rose as the European Central Bank hinted that it is nearing the time when it will begin to wind down its easy monetary policy. The emerging-markets fixed-income indexes posted solid returns in the second quarter, benefited by the low-volatility environment. The Morningstar Emerging Market Composite Bond Index rose 1.90%, as the underlying Morningstar Emerging Market Sovereign Bond Index rose 2.29% and the Morningstar Emerging Market Corporate Bond Index rose 1.69%. Asset Volatility Remains Near Historical Lows
Volatility in the asset markets has declined and is bouncing around near-historic lows. Some of the factors that helped suppress volatility range from the lack of surprises in the first-quarter earnings season, weak economic growth, a decline in debt-funded M&A, and diminishing geopolitical risk. In the equity market, the CBOE Volatility Index (VIX) declined to as low as 9.8 on May 8. Since 1990, there have been only three instances in which the index has registered lower. Market volatility and corporate credit spreads are highly correlated, as the spread of the Morningstar Corporate Bond Index and the VIX has an R-squared of approximately 85%. While growth is expected to accelerate in the second quarter, that acceleration may be short-lived. Robert Johnson, Morningstar Research Services LLC’s director of economic research, recently provided a midyear update to his economic forecasts. He reiterated most of the projections he made at the beginning of the year and continues to expect real GDP growth for 2017 to range between 1.75% and 2%. In addition, he established a new forecast for economic growth in 2018 to also range between 1.75% and 2%. Johnson has said he thinks the Fed will not hike the federal funds rate any further this year and is more likely to begin reducing the size of its balance sheet as early as the September Federal Open Market Committee meeting.