HG bond spreads widened 8bp on the week (through Wednesday), driven by higher UST yields and heavy bond supply. Negative total returns for HG bond funds in prior weeks led to modest outflows this week (3% of YTD inflows).

While there is a lot of market discussion that recent HG bond fund losses will lead to significant outflows, the historical correlation between returns and fund flows is actually weak. The current dynamic when rising UST yields are met with rising spreads is a relatively rare dynamic, occurring about 11% of the time over the past 3 and 10yrs. Much more common is negative correlation between the asset classes. The more important macro developments, in our view, are the enactment of a further $1.9tr stimulus plan, the vaccine rollout in the US picking up steam, and new reopening measures being announced daily around the country. These developments portend stronger growth and corporate earnings in 2021, with positive impacts on credit metrics down the road. There were also large M&A developments this week, which were a mixed bag for spreads overall (divestments positive for sellers versus releveraging negative for buyers). More M&A as the year progresses is a logical outcome of stronger economic growth, so long as funding yields remain relatively low.

Credit Derivatives HG bonds and bond index products have underperformed versus their CDS and CDX.IG over the past week. This has unwound most of the bond outperformance over the past 3 months. The optical spread floor of 50bp for CDX.IG has resulted in the index underperforming equity markets for most of the past few quarters. We believe the upcoming roll coupled with pension fund quarter-end rebalance could result in technicals favoring CDX.IG outperformance versus the equity market. Markit published the CDX.IG provisional roll changes on Wednesday. The IG roll fair value is around 7.25bp and we expect the roll to trade about 1bp tighter than fair value. We expect the CDX.IG S36 5s10s curve to trade at 40bp, resulting in CDX.IG steepeners on the new series appearing attractive. We updated our CDX.HY S36 roll forecast to 21bp wider/28 cents lower than CDX.HY S35. We expect CDX option volatility to remain elevated near term but expect implied volatility to “optically” decline by about 4% due to the roll.