A new part of the market is melting down as panicked investors get another ‘wake-up call’

• While stocks and Treasurys experienced violent selloffs, the credit market hung in there admirably.
• That changed this past week as investors pulled near-record amounts of capital from credit funds.
• Morgan Stanley warns of more credit market turbulence ahead, and reaffirms its 2018 forecast that US corporate bond returns will be negative.

During the recent market meltdown, one asset class remained a silent beacon of strength.

You may not have noticed as stocks and Treasurys took massive plunges, but corporate bonds hung in there quite nicely.

Hopefully fixed-income investors enjoyed the placidity while it lasted, because that all changed this past week, as corporate bonds became mired in a selloff of their own.

The damage is perhaps best viewed from the perspective of capital flows. Bond funds saw outflows of $14.1 billion during the week ended February 14, the fifth-biggest redemption on record, according to data compiled by Bank of America Merrill Lynch. Roughly $11 billion of that came from high-yield funds, the data show.

As such, credit markets face a crucial stretch that will determine how fleeting this selloff ends up being. Investors might very well step in and “buy the dip” amid tightening spreads, but the longer volatility persists, the more scared investors will get, according to Morgan Stanley.

Recent price swings in credit markets are “a wake-up call that central banks are withdrawing liquidity, and that the process is not going to be smooth,” Adam Richmond, Morgan Stanley’s head of US credit strategy, wrote in a client note. “We now have high conviction that liquidity dynamics are changing, that markets are finally becoming more aware of that reality.”

This cautious outlook aligns with Morgan Stanley’s 2018 forecast, which called for negative returns for corporate bonds in the US, Europe, and Asia. The firm has warned for months that increasing debt loads at companies could stir up trouble as interest rates move higher, making it more difficult for them to refinance. The pressure may also spur more fickle investors to flee the trade, Morgan Stanley has said in the past.

So with all of that in mind, what’s next? Even though it’s bearish on a longer-term basis, Morgan Stanley predicts credit markets will rebound from their ongoing selloff over the next two months, citing an economy that continues to grow.

The firm also notes that bullish sentiment has come down from recent highs into more neutral territory, leaving “a bit more bullishness” that “could get worked off in the very short term,” said Richmond.

But don’t let that temporary optimism fool you — Morgan Stanley is still very much bearish on the credit market this year. In fact, it’s gone as far as to recommend a sort of inverse buy-the-dip strategy:

“Rallies in credit should be sold,” said Richmond. “Credit markets will struggle over the course of the year.”