June 30th, 2017
The 2nd quarter saw overall credit markets trading near the tighter end of the last 5 years and unexciting upside in credit valuation across most sectors of the credit markets. Yet good financial performance in the most recent earnings season, optimism in upcoming earnings and continued liquidity in the market persist and have led to a lower spread environment. Despite frothy valuations, the economy has a reasonable chance to continue to improve, so a lower volatility, lower spread environment could persist for several months. In the industrial and non-financial sectors, tighter spreads coupled with rising leverage is cause for concern in corporate balance sheet health. In the treasury market, upside pressure on yields has been limited with low inflation and persistent demographic shifts in the aging workforce. Additionally, several overnight interest rate increases by the Fed has worked to bring some tightening to market conditions and the yield curve is considerably flatter. While many in the market were spooked by the Fed’s potential to shock the rate market into a more pronounced sell-off, higher overnight rates set by the FOMC coupled with late cycle economic activity has typically coincided with flatter or even inverted yield curves. In June, the Federal Reserve raised the benchmark rate for the second time this year. The current benchmark rate is between 1% to 1.25%. The market has priced a 55% probability of a December 2017 rate hike.
One of the bigger stories in a quarter with a dearth of outsized market moves was the persistent downward price pressure in the oil markets. West Texas Intermediate (“WTI”) crude oil traded at ~$55 per barrel in January 2017 and since then has trended lower despite production cuts by the OPEC countries. At the end of the second quarter, WTI was trading at ~$46 a barrel. Against the backdrop of volatile commodity prices and political concerns in the Middle East, energy and basic materials sector have traded wide to the market. All the banks that participated in the annual capital stress test (CCAR) passed and received approval by the Fed to hike shareholder returns. YTD, investment grade supply has been ~$760 billion with financials contributing to 45% of total issuance. The 10-year Treasury yielded 2.46% at the end of 2016 and decreased to 2.30% at the end of the second quarter. The 10-year Treasury traded as high as 2.6% on December 15, 2016. The yield on 30-year Treasury was 2.84% at the end of June from 3.06% at the end of December.
Within high-grade fixed income, credit spreads in the Barclays Aggregate Index tightened to 103 bps in June from 118 bps in December 2016. For context on credit spread history, spreads ended 2011 at 217 bps, 2012 at 131 bps, 2013 at 111bps, and widened to 125 bps at 2014 before widening further in 2015. The year-to-date excess return for the Barclays Credit Index was positive 148 bps along with longer duration credit outperforming duration neutral treasuries by 212 bps. At the sector level, spreads on Industrial credit tightened to 112 bps
in June from 125 bps off Treasuries at the Q4 2016 and 183 bps in December 2015. Year-to-date, the sector produced a positive 151 bps of excess return. Spreads in financial credit tightened to 103 bps from 120 bps at the end of 2016, and the sector produced a positive 163 bps of excess return YTD. Utilities also saw spreads tighten from 150 bps in 2015 to 117 bps in 2016 to 110 bps in June and posted positive 100 bps of excess return YTD.
In ABS, deeper subprime auto names were the best performers, as these bonds’ credit protection outweighs weaker relative consumer credit profiles within the trust. The bonds benefited from a strong rebound off misguided headlines pertaining to the sector that led to extremely attractive entry levels. Spreads in the MBS sector widened by 17 bps to 32 bps at the end of June from 15 bps at Q4 2016. Year-to-date the sector delivered a negative 20 bps of excess return. ABS spreads tightened by 13 bps from 59 bps in December to 46 bps, and the sector produced a positive 54 bps of excess return. CMBS spreads were relatively unchanged from 75 bps in 2016 to 74 bps at quarter-end. The sector produced a positive 42 bps of excess return. Year-to-date, the Barclays Aggregate Index posted a positive 2.27% total return.