Outlook 2017: Lower high-grade bond returns likely; banks, energy favored; bonds mostly firm

By Cristal Cody

Eureka Springs, Ark., Dec. 30 – Investment-grade bonds are expected to be impacted over 2017 with some sectors favored over others.

“The outcomes of Brexit and the U.S. election have brought fundamental change, which equates to investor opportunity,” Candace Browning, head of BofA Merrill Lynch global research, said in a news release. “If investors choose asset classes, sectors and stocks carefully, they can meaningfully outperform the market. 2017 could be the year of the active investor.”

While corporations are expected to benefit from tax cuts under U.S. president-elect Donald Trump, he also has voiced anti-globalization rhetoric and opposition to industry consolidation, including AT&T Inc.’s $85.4 billion cash and stock acquisition of Time Warner Inc. that was announced in October.

U.S. telecommunications and utilities likely will see pressure, while bank and energy sectors should see a positive impact in 2017, sources report.

Returns on high-grade corporate bonds are expected in the 3.5% to 4.5% area, according to BofA Merrill Lynch.

Investment-grade “corporate spread maturity curves may super-flatten as global credit investors sell shorter maturities and buy the long end,” BofA Merrill Lynch analysts said in a report. “A modest 20 [basis points] of spread tightening in 2017, generating a healthy 3% to 4% excess and 3.5% to 4.5% total returns, is expected. Corporate balance sheets are improving in the U.S. as earnings headwinds dissipate. Thirty-year corporate bonds could generate total returns of 8% to 9% in 2017.”

Credit spreads improve

Investment-grade credit spreads tightened more than 20 bps over 2016, sources note.

By Dec. 21, the Markit CDX North American Investment Grade index had come in to 66 bps, compared to where it ended Dec. 31, 2015 at 88 bps.

“While spreads are still above their lows of 103 basis points in June of 2014, our view is that despite the strong risk appetite due to potential expansionary fiscal policies, spreads most likely cannot tighten enough to offset the current rise in rates,” RBC Capital Markets, LLC analysts said in a report. “We still expect investment-grade corporate bonds to provide a positive return in 2017, but we find it unlikely investors will achieve the 5.3% returns seen thus far in 2016 – and expect between a 2.0% and 4.4% return as our most likely scenarios.”

RBC said that investor appetite for risk “continues to push spreads on corporate bonds tighter to similar maturing treasuries, with benchmark option adjusted spreads at 130 basis points, well inside of their five-year average of 152 basis points.”

Collin Martin, director of fixed income for the Charles Schwab Corp., said in a report that corporates still have room to outperform Treasuries in 2017, though total returns may not be as strong as in 2016.

“With yields potentially set to rise, income payments – rather than price appreciation – likely will be a bigger factor in total returns in 2017,” he said. “Investments with floating coupon rates may help investors earn higher yields when short-term interest rates rise, while also offering relative price stability.”

Bonds tighten over 2016

High-grade bonds mostly saw strong tightening over the year in the secondary market, according to trading sources.

Anheuser-Busch InBev Finance Inc.’s senior notes (A3/A-) brought in January in a $46 billion seven-tranche offering have tightened considerably by December.

Anheuser-Busch’s 3.65% notes due 2026 were quoted in mid-December trading 50 bps better at 110 bps bid.

The Leuven, Belgium-based brewery sold $11 billion of the 10-year notes on Jan. 13 at Treasuries plus 160 bps.

Apple Inc.’s $12 billion nine-part offering of senior notes (Aa1/AA+) that priced on Feb. 16 also has tightened significantly in secondary trading.

Apple’s 3.25% notes due 2026 came in to 86 bps bid by late December. The Cupertino, Calif.-based computer and mobile communications device company priced the $2 billion tranche on Feb. 16 at a spread of Treasuries plus 150 bps.

Bank and financial paper came in over the year, too, in the secondary market.

Bank of America Corp.’s 4.45% medium-term subordinated notes due 2026 that priced on Feb. 29 have tightened 100 bps since issuance to 170 bps bid in mid-December secondary trading.

The Charlotte, N.C.-based financial services company (Baa1/BBB+/A) sold $2 billion of the notes at a spread of 270 bps over Treasuries.

Elsewhere, Citigroup Inc.’s 3.7% subordinated notes due 2026 (Baa1/BBB+/A) brought to market on Jan. 5 have improved about 14 bps over the year. The New York-based financial services company’s notes (Baa1/BBB+/A) traded in late December at 134 bps bid, compared to where the $2 billion tranche priced at Treasuries plus 148 bps.

In the retail sector, Home Depot Inc.’s 3% senior notes due 2026 (A2/A/A) that priced on Feb. 3 were ending the year more than 50 bps better at 66 bps bid. The Atlanta-based home improvement retailer sold $1.3 billion of the notes at a spread of 120 bps over Treasuries.

Walgreens Boots Alliance Inc.’s notes (Baa2/BB/BBB) that priced in a $6 billion five-part deal on May 26 were mostly better on the year. The Deerfield, Ill.-based drugstore chain’s 3.45% notes due 2026, priced in a $1.9 billion tranche at a spread of Treasuries plus 165 bps, traded in mid-December at 128 bps bid.

“The outcomes of Brexit and the U.S. election have brought fundamental change, which equates to investor opportunity,” – Candace Browning, head of BofA Merrill Lynch global research, in a news release

“We still expect investment-grade corporate bonds to provide a positive return in 2017, but we find it unlikely investors will achieve the 5.3% returns seen thus far in 2016 – and expect between a 2.0% and 4.4% return as our most likely scenarios.” – RBC Capital Markets, LLC analysts in a report

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