Outlook 2018: High-grade spreads forecast to tighten, give back gains in back half of year

By Cristal Cody

Tupelo, Miss., Dec. 29 – Investment-grade credit and bond spreads are initially forecast to firm in 2018 before ending mostly flat on the year.

“U.S. credit spreads are expected to tighten in the first half of 2018 as excess demand conditions prevail, and then to give that back in the second half,” according to a BofA Merrill Lynch market report. “Total returns of 2.2% are forecast for U.S. high-grade corporate bonds.”

Hans Mikkelsen, head of U.S. high grade strategy at BofA Merrill Lynch, gives a high-grade spread target of 95 basis points on BofA Merrill Lynch’s investment-grade bond index for mid-year 2018 and back to the year-end 2017 area of 100 bps by the end of 2018.

“The expected spread of 100 bps on our U.S. high grade index at the end of this year provides enough cushion to offset 17 bps of spread widening by the end of 2018 before high grade corporate bonds underperform Treasuries,” he said in a research note. “If the spread curve flattens, as we expect, high grade spreads could widen 28 bps before underperforming Treasuries.”

Spreads are forecast to widen significantly by 10 bps to 20 bps in the front end on five-year notes and shorter and tighten on maturities of 15 years and more, according to the note.

U.S. fixed income technicals are expected to be more challenging in the second half of the new year with buyers wanted, Mikkelsen said.

“Reasons for this shift include the Fed's accelerating balance sheet reductions,” he said. “At the same time demand for bonds declines as lower returns lead to less inflows to fixed income bond funds/ETFs. Crucially we expect rising interest rates in Asia by mid-year to lead to a loss of some foreign inflows as well.

“The net result is that other investor types need to step up and buy almost $1 [trillion] of U.S. fixed income in 2018 – mostly in 2H – up sharply from just $200 [billion] in 2017. That raises the risk of higher yields/spreads.”

New issues firm in 2017

Credit spreads set or tied new post-financial crisis lows in December, while the real estate, services, banking and transportation sectors also set or tied post-crisis lows in the last week of trading before the Christmas Day holiday, a market source said.

The Markit CDX North American Investment Grade 29 index tightened about 1 basis point to close on Dec. 20 at a spread of 49 bps.

The S&P Global Ratings investment-grade composite spread tightened 3 bps during the session to 137 bps, a new post-financial crisis low first set at 140 bps on July 30, 2014, a source said.

New issues priced during the record year of volume remained mostly tight in the secondary market as the year closed.

AT&T Inc.’s senior notes (Baa1/BBB+/A-) that priced in a $22.5 billion seven-tranche offering on July 27 were better than issuance, a market source said.

AT&T’s 3.9% notes due Aug. 14, 2027 traded in the 143 bps bid area in mid-December.

The Dallas-based telecommunications company sold $5 billion of the notes in the July 27 offering at a spread of 160 bps over Treasuries.

AT&T’s $85.4 billion cash and stock takeover of Time Warner Inc. was expected to close by the end of 2017 until the Justice Department filed a lawsuit to stop the transaction. A trial is set for March.

Verizon Communications Inc.’s senior notes (Baa1/BBB+/A-) that priced in five tranches in an $11 billion offering on March 13, 2017 have tightened considerably in the secondary market, a source said.

The tranche of 4.125% notes due March 16, 2027 were trading in December at 114 bps bid.

The New York City-based telecommunications company sold $3.25 billion of the notes at a spread of Treasuries plus 160 bps.

Amazon.com, Inc.’s senior notes (Baa1/AA-), which were brought to the primary on Aug. 15 in a $16 billion seven-part offering, also were ending the year stronger.

The company’s 3.15% notes due Aug. 22, 2027 were quoted in the 69 bps bid area in secondary trading in December.

Amazon.com sold $3.5 billion of the notes on Aug. 15 at a spread of Treasuries plus 90 bps.

The Seattle-based online commerce company closed in August on its $13.7 billion acquisition of Whole Foods Markets Inc.

Apple Inc.’s $10 billion of senior notes (Aa1/AA+) that priced in nine tranches on Feb. 2, 2017 continued to trade better than issuance as the year closed.

The company’s 3.35% notes due Feb. 9, 2027 were quoted by a market source trading in mid-December at 71 bps bid.

Apple sold $2.25 billion of the notes at a spread of Treasuries plus 88 bps.

Apple’s 4.25% notes due Feb. 9, 2047 traded in December at 91 bps bid.

The Cupertino, Calif.-based computer, mobile communication and media devices company sold $1 billion of the bonds at a 115 bps spread over Treasuries.

“U.S. credit spreads are expected to tighten in the first half of 2018 as excess demand conditions prevail, and then to give that back in the second half.” – BofA Merrill Lynch in a market report

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