Good credit metrics and fewer M&A transactions using debt are giving a boost to corporate credit markets, according to Morningstar. This has put the average spread of the Morningstar Corporate Bond Index at its lowest level since before the credit crisis.
Other factors giving corporate credit markets a boost are fewer “shareholder-enhancement programs,” and expectations that the new to tax and regulatory landscape “will bolster corporate credit strength by invigorating economic growth and boosting earnings.”
Morningstar also points to economic outlook as bolstering corporate credit. The Fed has also been a factor. “Between raising the federal-funds rate three times in 2017 and initiating its balance sheet normalization program last October, the Federal Reserve is well on its way to normalizing monetary policy,” Morningstar says. “In anticipation of the increases in the fed-funds rate, the yield on the 2-year Treasury bond has been steadily rising over the past few years. However, the increase in interest rates across the longer-term portion of the yield curve has lagged the short-term as inflation and inflation expectations remain muted. As such, the spread between 2-year and 10-year Treasury yields has compressed significantly. At its current level, the yield curve is its flattest since October 2007.”
Morningstar says that when yield curve has flattened in the past, it’s been an indicator of a weakening economy “and in many cases portended an impending recession.” However, due to influence of global central bank actions, this may not be the case. And based on Fed’s statements and forecasts and the promise of more rate hikes, “it appears that short-term rates may continue to head higher in 2018,” Morningstar says.
Meanwhile, on the long end, rates are being driven by “the ongoing quantitative easing programs of the European Central Bank and the Bank of Japan.” So the flattening trend “may continue to be influenced by global central bank monetary policy.”
Morningstar says the average spread of its Corporate Bond Index tightened 2 basis points and last week at +91, its lowest level in more than a decade. Year-to-date, “the average credit spread of the overall investment-grade index has tightened 5 basis points. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 12 basis points to end the week at +323, which is already 40 basis points tighter than at the end of 2017.” The last time it was this tight was June 2007.
The tighter corporate spreads are leading to optimism generally for the economic outlook. Morningstar says “financial conditions” in the US are improving. “The outlook for continued economic expansion appears likely as the average consensus forecast for GDP growth in the first quarter of 2018 is 2.5% and the full-year forecast is 2.7%,” Morningstar points out. And the current state of financial conditions means that will continue. Morningstar points to the Federal Reserve Bank of Chicago’s weekly index that measures more than 105 variables to gauge how loose or tight financial conditions are in US capital markets and the traditional and shadow banking systems. These include credit availability and cost, leverage, risk, interest rates, and credit spreads. Index levels above zero indicate tighter-than-average conditions, whereas levels below zero represent looser-than-average conditions. Currently, the Chicago Fed’s National Financial Conditions Index shows financial conditions are their loosest since October 1994.