Corporate Bond Market Normalizes After Record-Breaking Issuance at Beginning of Month

After setting new records at the beginning of September for the greatest amount of new-issue volume brought to market in a single week, activity in the corporate bond market continued to normalize last week. Institutional trading action in the secondary market focused on trading new issues that had been brought to market over the past three weeks as portfolio managers rightsized their positions to capture where they see relative value. As this paper was being shuffled around, credit spreads tightened modestly as demand from global fixed income investors for U.S. dollar-denominated securities remained solid. In the investment grade market, on a week-over-week basis, the Morningstar Corporate Bond Index tightened 1 basis points to +117 and in the high-yield market, the ICE BofAML High-Yield Master II Index tightened 2 basis points to +381.

As expected, the Federal Reserve lowered the federal funds rate by 25 basis points on Wednesday to a range of 1.75% to 2.00%. This is the second interest rate cut by the Fed since it began to lower rates following the August 2019 meeting of the Federal Open Market Committee, or FOMC. While this reduction was completely expected by the market, the forecast for further monetary action has become increasingly murky. Three of the voting members dissented against this action as two members voted to keep interest rates unchanged, while another voting member thought the rate should have been cut by 50 basis points.

Looking forward through the rest of 2019, the market-implied probability that the Fed will cut rates again by the end of the year has declined. According to the CME’s FedWatch Tool, the probability that the Fed will hold rates steady at the current range has increased to a 38% probability from a 20% probability one month ago. The probability of one rate cut has held steady at 48% and the probability of two rate cuts has decreased to 14% from 31% one month ago.

According to the Fed’s own “Summary of Economic Projections”, which were released along with the press release for the meeting, only seven of the members on the committee expect the Fed to cut rates by another 25 basis points to a range of 1.50% to 1.75% by the end of 2019. Five of the members expect the federal funds rate will be held steady at its current range of 1.75% to 2.00% and another five members expect the Fed will raise the rate to a range of 2.00% to 2.25%.

The differing outlook is based on the high degree of uncertainty over potential contagion of slowing economic growth in Asia and Europe spreading to the U.S. economy, the effect of ongoing trade conflicts, and a disparate outlook on inflation. Currently, according to the Federal Reserve Bank of Atlanta, its GDPNow model estimate for real GDP growth in third-quarter 2019 is 1.9%; whereas, the Nowcast as calculated by the Federal Reserve Bank of New York for third-quarter GDP is slightly more positive at 2.24%.

On one side of the argument, that the federal funds rate should have been lowered even further, is Jim Bullard, President of the St. Louis Federal Reserve Bank. He voted for a cut of 50 basis points because he sees signs the U.S. economy is expected to slow in the near term and inflation and inflation expectations continue to run below the FOMC’s 2% inflation target. On the other side of the argument, several members do not think additional monetary stimulus is needed currently. They point to the low unemployment rate and other employment metrics that indicate employment markets are already tight, current monetary policy is already highly accommodative, and low interest rates may be distorting asset prices and encouraging debtors to take on too much leverage.

While the cut to the federal funds rate grabbed the headlines, in a little-known and even less understood corner of the marketplace, the rate for overnight repurchase agreements skyrocketed in the middle of last week as a dislocation occurred between liquidity providers and those that fund themselves with overnight debt. A repurchase agreement is a short-term funding agreement in which a lender will purchase high-quality securities (typically U.S. Treasury bonds, agency bonds, or highly rated corporate bonds) with an agreement that the seller will repurchase those same securities the next day at a set price. The dislocation that occurred last week temporarily sent the annualized interest rate on these agreements as high as 10%. The Fed quickly stepped into this void and conducted several of its own repurchase auction programs to provide the needed liquidity. In addition, on Friday the Fed announced it would continue to offer up to $75 billion of daily overnight repurchase operations until Oct. 10 and would also conduct three $30 billion 14-day term repurchase operations. At the end of the week, while the funding rate on these agreements remained slightly higher than where short-term interest rates would typically dictate market terms, the rate had substantially normalized. While several explanations have surfaced to try to explain what caused this short-term disruption, none of these explanations have been able to describe fully why this event occurred.

After selling off the prior week, the demand for U.S. Treasury bonds picked up again. While the increase in bond prices was not enough to recapture all the losses from the prior week, Treasury bond yields decreased towards their recent lows. In the short end of the curve, the interest rate on the two-year bond decreased 12 basis points to 1.68% and the 5five-year bond fell 15 basis points to 1.60%. In the longer end of the curve, the yield on the 10- and 30-year bonds declined by 18 and 21 basis points respectively, to 1.72% and 2.16%, respectively.

Investors continued to pour money into the high-yield asset class last week. Weekly net inflows increased to $3.1 billion last week (the third greatest weekly inflow over the past 52 weeks) compared with the $2.1 billion inflow the prior week. Similar to two weeks ago, the increase was mainly driven by institutional investors. Net unit creation among the high-yield exchange traded funds, or ETFs, rose to $2.0 billion last week compared with $1.2 billion the prior week. Asset flows among the ETFs is typically considered a proxy for institutional and hot-money investors. Among the open-end high-yield mutual funds, inflows rose to $1.1 billion, a slight increase from $0.9 billion inflows the week before. Historically, flows among the open-end funds have been attributed to individual investor demand.

Year to date, t­­here has been a total of $19.1 billion of net inflows into the high-yield asset class. Most of the inflows have been driven by $13.7 billion of net unit creation across the high-yield ETFs as the open-end funds have only received $5.8 billion of new investment.

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