This article was originally published on Morningstar.com. All bonds mentioned are issued by US corporates meaning the commentary has a bearing on global bond funds.
In our third-quarter corporate credit outlook published Sept. 25, we outlined why we thought corporate credit investors were poised to begin recapturing their losses suffered this summer. Since then, the Morningstar Corporate Bond Index has risen 1.12% and is now down only 1.49% year to date. We continue to think the corporate bond market will recover in the short term. Interest rates are likely to continue to decline due to the Federal Reserve's on-going asset-purchase program, and the demand for corporate bonds will push corporate credit spreads tighter. Fund flows into bond funds have returned, and as the Fed's asset purchases remove Treasury and mortgage-backed bonds from circulation, demand for corporate bonds has improved. Last week, this increased demand helped to reduce the average credit spread in the Morningstar Corporate Bond Index by 5 basis points to 138 over Treasuries.
We continue to believe that from a long-term fundamental perspective, corporate credit spreads are fairly valued in the current trading range. However, over the near term, because of the Fed's quantitative easing program providing a steady flow of liquidity into the markets, we expect corporate credit spreads will probably be pushed to the bottom of this year's trading range. The tightest credit spread in our index reached +129 on May 15. Across Morningstar's coverage universe, our credit analysts generally hold a balanced view that corporate credit risk will either remain stable or improve slightly, but that tightening credit spreads will generally be offset by an increase in idiosyncratic risk such as debt-funded M&A, increased shareholder activism, and so on.
The new issue market in the US was relatively quiet last week, as only a few issuers braved the headlines to bring deals to the market. The transactions that came to market were originally talked at somewhat attractive concessions to existing trading levels. Due to strong demand, these whispered concessions mostly disappeared when the deals were priced and the bonds performed well in the secondary market. Fund inflows are pressuring portfolio managers to put cash to work, but there has not been enough new issuance to satisfy demand. We think last week's successful offerings, tightening credit spreads, and lower interest rates will prompt other issuers and underwriters to bring more new issues to market this week.
With new issue market volume moribund over the past few weeks, investors have only had the secondary market in which to invest cash. Bonds from well-regarded issuers that were offered for sale in the secondary market immediately found buyers. While most bonds quickly traded, there is still a batch of bonds on offer that haven't traded. These bonds have largely been picked over, and there is a reason those bonds haven't traded - typically due to either weak credit quality or other catalyst-driven concerns. While it's tempting to reach for additional spread in this environment, we caution investors to remain judicious.
