Barclays sees 'limited upside' ahead in non-financial high-grade bonds but likes financials

By Paul Deckelman

New York, June 23 - Investment-grade bonds have done all right so far this year - but that run may be just about over for the non-financial side of the high-grade world, according to Barclays Capital, which sees just "limited upside" in U.S. and European industrial and other non-financial corporates at current valuations, in terms of both spreads and all-in yields.

The view comes even after the recent bout of fixed-income spread widening in response to investor concerns about macroeconomic problems.

The big investment bank put out its quarterly outlook for various asset classes on Thursday - and declared that "the potential for further fundamental improvements in corporate balance sheets seems limited, and an increasing number of companies are becoming more aggressive with shareholder-friendly activity," i.e., devoting generated cash to buying back shares, instituting dividends, or raising the ones they now have, rather than using it to cut debt.

"We expect more pressure on companies to return money to shareholders, which could reverse some of the fundamental improvements of the past several years," Barclays warned, adding that while spreads have increased somewhat from their prior tight levels, "we believe the likely stabilization/reversal of fundamentals limits the potential for further tightening."

The report went on to say that "we believe the deleveraging cycle [in investment-grade non-financials] has largely ended."

The report noted that average investment-grade non-financial leverage at U.S.-based companies was flat during the first quarter - after having shown quarterly declines consistently since early 2009.

Bullish on financials

But the good news for high-grade investors is that Barclays is bullish on financial corporates.

"By contrast [with the non-financials],we continue to see value in financials, which have underperformed over the past several weeks due to renewed uncertainty about regulatory interference, potentially adverse effects from a near-term default in Greece, or, alternatively, private sector involvement in its financial rescue," the Barclays outlook said, also citing renewed weakness in the U.S. housing market and the prospect of greater losses in mortgage portfolios as a factor acting as a drag on the bonds of banks and other financial companies.

As a result of that recent underperformance, Barclays believes that investment-grade financials "currently offer significant pickup" over non-financials. Going back a bit, the Barclays analysts theorized that while spreads [in the financials group] are likely to remain volatile in the near-term, each selloff over the past 18 months has been a buying opportunity, and the broader trend of compression versus non-financials has eventually taken hold."

Barclays does remain wary about European financials, although even there, it is mostly senior unsecured bank credit that is a matter of concern.

Barclays cautioned that "ongoing moves to potentially subordinate unsecured creditors to depositors, the potential for senior 'haircuts' at certain peripheral banks and relatively tighter spreads" combine to make that unsecured debt less attractive. Barclays also believes that "supply will likely remain a greater overhang in Europe, given the heavier redemption schedule for European banks, versus U.S. banks, the limited access to term unsecured funding for many peripheral European banks and the increase in covered bond (secured) issuance in that market."

European banks an opportunity

That having been said, Barclays, while acknowledging that paper of European banks faces greater volatility, "in our view, given the likely continued overhang of sovereign concerns, we see considerable opportunities in that market for long-term investors" - although with the caveat that they will have to remain "more selective" about those credits.

Investment-grade issuers have been busy so far this year, and Barclays sees that trend continuing - up to a point.

As of the middle of June, issuers had brought some $475 billion of new paper to market, running about 20% ahead of year-ago levels; the bank cites as factors low yields, improving market conditions, a pick-up in merger and acquisition activity and the end of the deleveraging cycle.

"Opportunistic issuers looking to lock in low yields and European banks looking to diversify their sources of funding in the [U.S. dollar] market have been key drivers of supply so far," its report said, noting the fact that non-U.S.-based issuers accounted for nearly half of all year-to-date high-grade issuance, driven primarily by favorable swap-spread dynamics and European banks' sizable funding needs.

Barclays is now projecting that gross investment-grade issuance this year should come in at $825 billion, a $60 billion gain from the $765 billion estimate it released earlier in the year, with the overall level of yields, dynamics in the pace of corporate re-leveraging and M&A activity likely to be the main drivers.

However, Barclays only upped the anticipated full-year issuance of its non-financials segment by about 15%, to $530 billion from the original $455 billion, and it actually cut its forecast for issuance by financial names to $295 billion from $310 billion originally.

Barclays cautioned that if current macroeconomic concerns persist, "there could be an extended supply drought." It also noted the fact that "the most opportunistic issuers have likely come to market already" as possibly putting a damper on high-grade new issuance for the remainder of the year.

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