Outlook 2016: High-grade bond spreads forecast to firm; banks outperform; mining, energy weak

By Cristal Cody

Tupelo, Miss., Dec. 31 – Investment-grade corporate bond spreads are expected to retrace some of 2015’s losses and tighten modestly over the coming year.

High-grade bond spreads widened 25 basis points in 2015 to 155 bps from 130 bps, according to Barclays Bank plc analysts.

Spreads are expected to tighten modestly over the year by 10 bps to 20 bps in the U.S. market and 5 bps to 10 bps in Europe, Barclays said.

“The key difference is that the driver for spread tightening in Europe is financials, and in the U.S., it is industrials,” the Barclays analysts said. “Subordinated financials should post the best returns, as the financial sector has become lower beta and there is room for compression versus senior bonds.”

BofA Merrill Lynch analysts forecast a 15 bps to 20 bps tightening to 135 bps in the U.S. high-grade sector in 2016.

“2015 has not brought much joy for credit market performance across the globe,” the BofA Merrill Lynch analysts said. “Excess returns have been negative for U.S. high-grade, U.S. high-yield and European high-grade. While 2015 was about too many bonds chasing too little money, in 2016 we return to an environment of too much money chasing too few bonds.”

BofA Merrill Lynch analysts expect foreign buyers in search of yield in the U.S. high-grade market to be “significant” in 2016.

The “biggest risk for high grade credit investors next year is a much more aggressive pace of rate hikes leading to a more significant increase in long term interest rates, prompting big outflows,” BofA Merrill Lynch analysts said.

Stocks likely will continue to outperform credit in early 2016, the analysts said.

The Markit CDX North American Investment Grade 25 index outperformed cash for the third year in a row, Barclays said, “but this is unlikely to repeat in 2016 due to the relative attractiveness of cash, the already-sizable client long base in CDX, and the skewed distribution of underlying CDX constituents.”

The Markit CDX North American Investment Grade 25 index was at a spread of 95 bps in late December.

The CDX high-grade index has ranged from a low spread of 60.7 bps to a high spread of 96.8 bps over the past 12 months, according to Barclays.

The CDX remains the most liquid way to gain diversified investment-grade exposure, Barclays said.

“Demand should be more supportive in 2016, with higher long-dated investment-grade yields likely to encourage insurance company buying,” Barclays said. “It will be important to watch how positioning changes in 2016. Meaningful reductions in investor longs could either be a sign of growing risk aversion among credit investors, or a reflection of the relative value of cash becoming even more compelling.”

High-grade investors

Insurance companies, the largest single buyer of corporate bonds, did not add any net holdings in the first half of 2015 because of the low all-in yields, Barclays said.

Life insurance investors are estimated to have owned 30% to 34% of high-grade bonds in 2015, down from 32% to 36% in 2014.

During 2015, mutual funds, corporate Treasuries and foreign buyers picked up the slack in buying investment-grade corporate bonds.

Mutual fund bond ownership rose to 16% to 18% in 2015 from 15% to 17% in 2014, according to Barclays.

The amount of investment-grade bonds held by corporate Treasuries rose to 5% to 7% in 2015 from 4% to 6% in 2014.

“Mutual funds and corporate treasuries have each gained about 1% of market share,” Barclays said. “Fixed income mutual funds have increased corporate allocations roughly 1-2% relative to other asset classes, with the share of investment grade rising from roughly 55% to 60%. Meanwhile, corporate treasuries have shifted exposure from short-dated Treasuries to high-quality corporates in search of higher yields as the yield gap between front-end Treasuries and corporates has more than doubled since 2006.”

Pension funds’ holdings of 16% to 18% of high-grade bonds were flat year on year.

Hedge fund investment holdings were down to 1% to 3% in 2015 from 2% to 4% in 2014, according to Barclays.

Banks trade at tights

The spread widening in 2015 mostly was driven by the record $1.2 trillion of investment-grade corporate bond supply, including the substantial growth in volume driven to fund large mergers and acquisitions, according to Barclays.

Bank paper and single-A bonds have been the strongest outperformers over the last 12 months, BofA Merrill Lynch said.

U.S. investment-grade bank and financial paper is “trading at their tightest level to industrials since 2006, with roughly 15 [bps] of relative tightening so far this year,” Barclays analysts said.

Bank of America Corp.’s 4% notes due 2025 that priced at the start of 2015 ended the year better than issuance trading at 212 bps bid in late December, a market source said.

The Charlotte, N.C-based financial services company sold $2.5 billion of the notes (Baa2/A-/A) on Jan. 16 at Treasuries plus 225 bps.

Goldman Sachs Group Inc.’s 3.5% senior notes due 2025 (Baa1/A-/A) that priced in January and reopened in March were trading at 154 bps bid in December, a market source said.

Goldman originally sold $1.7 billion of the notes on Jan. 20 at 170 bps over Treasuries. The New York City-based financial services company reopened the notes on March 25 in an $800 million tap at Treasuries plus 145 bps.

JPMorgan Chase & Co.’s 3.125% notes due 2025 traded tight at 134 bps bid as the year came to a close.

The New York City-based financial services company sold $2.5 billion of the notes (A3/A/A+) on Jan. 16 at Treasuries plus 145 bps.

“The outperformance of financials continues a pattern that has been in place most years since 2009, but rather than being driven by greater tightening in bank spreads, it seems to have been caused by industrials widening on elevated M&A-driven supply and exposure to declining commodities,” Barclays analysts said.

Metals & mining, energy weak

Metals and mining as well as energy were the two widest trading sectors in 2015, according to market analysts.

“A further decline in oil prices in 2H-2015, combined with a drop in U.S. natural gas prices, led to renewed weakness in the energy sector,” BofA Merrill Lynch analysts said. “This resulted in sector spreads reaching to the widest levels in high grade behind only the troubled metals & mining sector.”

In the secondary market in December, senior notes (Baa2/BBB-) that Anglo American Capital plc, the financing arm of London-based mining company Anglo American plc, priced in May were trading weaker.

Anglo American announced in December that it plans a restructuring that includes cutting about 85,000 jobs, consolidating businesses and suspending the company’s dividend for the second half of 2015 and for 2016.

Anglo American Capital’s 3.625% notes due 2020 traded in early December between 79.063 to yield 9.53% and 78.25 to yield 9.8%, and a spread of 785 bps to 812 bps, a trader said.

Anglo American Capital sold $850 million of the notes on May 7 at 99.778 to yield 3.674%, or a spread of Treasuries plus 212.5 bps.

The company’s 4.875% notes due 2025 traded from 72.053 to yield 9.41%, or a 714 bps spread, to 71.00 to yield 9.62% and a spread of 739 bps in December.

Anglo American priced $650 million of the notes in the May 7 offering at 99.578 to yield 4.929%, or Treasuries plus 275 bps.

Marathon Oil Corp.’s senior notes (Baa1/BBB/) have moved out since pricing in June.

The company’s 3.85% notes due 2025 traded at 440 bps bid in late December, according to a market source.

The Houston-based energy company sold $900 million of the notes on June 1 at a spread of Treasuries plus 170 bps.

Southwestern Energy Co.’s 4.95% senior notes due 2025 (Baa3/BBB-) widened to 803 bps bid in December. The Houston-based independent natural gas and oil company sold $1 billion of the notes on Jan. 20 at 318 bps over Treasuries.

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