Outlook 2014: Investment-grade spreads forecast to remain stable; financials may outperform

By Cristal Cody

Tupelo, Miss., Dec. 31 - Investment-grade bond spreads likely will remain moderately tighter and stable in a repeat of 2013, with some sectors such as financials performing the best in trading in 2014, according to market sources.

"We expect the same mode we've been in the last three to six months, relatively low rates and tighter spreads, in the first quarter," a trader said. "We'll probably still see a heavy calendar of issuance, both in investment-grade and high-yield. I can't foresee any huge moves because the Fed mentioned they will try to keep rates low."

The Federal Reserve announced at the December policy meeting that the central bank will taper its asset securities purchases by $10 billion, to a monthly repurchase rate of $75 billion.

According to a Standard & Poor's report, corporate yields for investment-grade paper are expected to be mostly unchanged in the upcoming year from 2013 levels.

"In the U.S., for example, option-adjusted bond spreads for investment-grade entities in 2013 held between the narrow range of 176 basis points and 192 bps," S&P said.

The Markit CDX North American Investment Grade index started the year in the 90 bps area. The CDX rolled to a new index, series 21, on Sept. 19, and spreads increased by about 10 bps due to the extension in maturity. In December, the CDX firmed to a spread of 68 bps.

During 2013, the long end of the investment-grade bond market outperformed, while 10-year bonds fared the worst across all tenors, according to a Barclays report.

The intermediate part of the bond curve generated 126 bps of excess return, lower than the one-year to three-year bucket, which has significantly lower duration, Barclays said.

Since 2007, the U.S. Corporate Index has traded to 130 bps "a number of times, but has had difficulty breaking through this apparent floor," Barclays said. "We think the barrier is due to changes in liquidity, the financials/industrials relationship, and market structure. Tightening of more than 15 bps will be difficult through 2014, in our view."

Challenging year ahead

Fixed income investors also may have a challenging year due to tighter spreads, though corporates are favored over government bonds, BofA Merrill Lynch Global Research said in a report.

"The siren song of equities will lure retail investors away from U.S. investment-grade bonds, even in sectors whose returns are positive in 2014," BofA Merrill Lynch said. "But institutional investors, including insurers, sovereign wealth funds and foreign central banks support U.S. corporate bonds. We even expect U.S. pension funds to do a "reverse rotation" - selling stocks and buying bonds."

Among investment-grade bonds, Europe should lead the way with a return of up to 2%, followed by the United States at 1.5%, BofA Merrill Lynch said.

Market keeps appetite

Secondary trading is expected to be dominated by new issuance in the year ahead, with as much as $1 trillion of deals projected for the third consecutive year, sources said.

"The calendar looks pretty busy with a forecast of $900 billion gross of IG issuance," one market source said. "Trading activity will be pretty active relative to this year."

Mega deals including the $17 billion offering from Apple Inc. in April and the record $49 billion transaction from Verizon Communications Inc. in September were proven feasible for the market to take down, sources said.

"Deals approaching the size that Apple and Verizon offered in 2013 were inconceivable just a few years back, and yet both were very well received by the market," Standard & Poor's said. "Assuming investor appetite for these large deals doesn't dissipate, it is likely that we will see some companies come to market with big offerings again in 2014."

Verizon's eight-tranche offering of notes (Baa1/BBB+/A-) tightened considerably in the secondary market after the issues priced on Sept. 11, according to traders.

The New York City-based telecommunications company sold an $11 billion tranche of 5.15% notes due 2023 with a spread of Treasuries plus 225 bps. By the next day, the issue had tightened to 180 bps bid, 177 bps offered.

The week before Christmas, the 10-year notes traded at 142 bps bid, 139 bps offered, a trader said.

Verizon's long-dated tranche of 6.55% bonds due 2043 priced in a $15 billion offering with a spread of Treasuries plus 265 bps.

The bonds tightened to 157 bps bid in the secondary market in December, according to a trader.

Financials: Room to improve

During 2013, bonds in the industrial sector outperformed, along with utilities, a market source said.

Over the upcoming year, BBB-rated bonds likely will be stronger, and financial paper is expected to be among the outperformers in the secondary market, sources said.

In late December, bank paper tightened in response to the Federal Reserve's taper announcement, traders said.

Financial paper remains about 25 bps wider versus industrial bonds than they were in early 2007, according to a Barclays report.

"Financials will probably outperform the market more than anything else just for the fact they have been the widest of any of the asset classes out there," a trader said.

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