3Q 2017 Investment Grade Credit Market Commentary
Spreads moved close to multi-year tights during the quarter due to the combination of
an improved macroeconomic backdrop and strong corporate fundamentals. In addition,
reduced expectations of monetary tightening helped risk assets outperform because
central banks took a more dovish tone due to weak inflation data. Despite escalating
tension with North Korea, volatility remained exceptionally low during the quarter. Lately,
credit spreads have generally been driven by macro factors rather than sector-specific
issues. This is evidenced by the dispersion of spreads by sector, which is now at a multiyear
The synchronized global economic upturn continued in the third quarter. However,
inflation remains weak, causing global central banks to stay dovish and reduce fears
of a rapid adjustment to monetary policy. Nevertheless, the U.S. Federal Reserve (Fed)
remains committed to a gradual reduction in monetary accommodation and announced
plans to taper the size of its balance sheet beginning in October.
The Treasury curve flattened during the quarter, with short-term interest rates rising
faster than longer-term rates. The two-year U.S. Treasury rate rose 0.10% while the fiveyear
U.S. Treasury rate rose 0.05%. The 10-year and 30-year rates each increased 0.03%.
The slope of the two-to-ten-year Treasury curve fell from 0.92% to 0.85%.
The Bloomberg Barclays Capital U.S. Corporate Index, a proxy for the overall corporate
fixed-income market, had an excess return of 0.87% when compared to similar-duration
U.S. Treasury securities. Excess return performance was consistent across sectors, with
utilities returning 1.05%, financials 0.86%, and industrials 0.85%. The best-performing
industries were metals & mining, refining, independent energy, oilfield services, and
integrated energy. The worst-performing industries were lodging, supermarkets, cable
satellite, other finance, and packaging. Emerging market debt and high yield corporate
bonds also had positive excess returns during the quarter at 1.86% and 1.60%,
Outlook and strategy
Continued global economic strength remains supportive of valuations. Ongoing asset
purchases by central banks globally will contribute to continued investor demand
for yield. However, expectations for reductions in stimulus will be a key test of
market volatility. Additionally, uncertainty regarding the implementation of the U.S.
presidential administration’s tax-reform policies remains a key risk.
Fundamentals within investment grade corporates remain stable. Earnings are
improving although leverage continues to be relatively high. Technicals remain strong
because investors continue to seek the yield and liquidity of the sector. Spreads are
likely range-bound, with modest tightening potential.
Within the investment grade corporate allocation, main portfolio industry
overweights include U.S. money center banks, Yankee banks, healthcare, tobacco,
wirelines, and paper. Primary underweights include property and casualty insurance,
finance companies, capital goods, integrated energy, refining, pharmaceuticals,
automotive, and retailers.
Within below investment grade corporate bonds, corporate balance sheets remain
stable and default rates continue to decline. Technicals are mixed with volatile retail
fund flows. However, net new-issuance remains low, with the majority of issuance used
for refinancing. Yields provide a cushion against rising rates although upside potential
is limited. The portfolio’s out-of-index allocation to below investment grade corporate
bonds was maintained due to stable fundamentals.
A modest increase in growth in emerging markets has been sustained this year, with
a slow pace of global rate-increases providing breathing room. However, emerging
market economies are likely to see some slowing heading into year-end. Technicals are
strong due to record fund inflows and negative net new issuance. Valuations are mixed
and opportunities remain company and region specific. Due to strong technicals,
exposure to the sector remains overweight.
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