Outlook 2019: Continued softness in high-grade bond spreads eyed for market in 2019

By Cristal Cody

Tupelo, Miss., Dec. 31 – Wider spreads are on the horizon for the high-grade bond market in 2019.

Investment-grade spreads are predicted to widen about 20 basis points to 25 bps in 2019, according to a BofA Merrill Lynch research report.

High-grade spreads were ending 2018 on average 39 bps wider at 159 bps, J.P. Morgan Securities LLC analysts said in a report.

“We expect them to widen modestly further to 170 [bps] by YE19,” the analysts said. “Both higher spreads and higher UST yields have led to negative returns this year.”

Investment-grade bond spreads are 50 bps off their tightest point in February 2018 and back to levels seen in December 2016, the analysts said.

In 2018, high-grade bond yields hit a seven-year high, while bond prices were $11 lower than their 2016 peak.

“Rising FX hedging costs are the key reason that HG bond spreads widened this year as they discouraged foreign investment,” according to the JPMorgan analysts. “We expect higher costs in 2019.”

Spreads widen

Credit spreads also widened in 2018.

The Markit CDX North American Investment Grade 29 index began the past year at a spread of 48.5 bps. By the end of 2018, the index had rolled over, and the Markit CDX North American Investment Grade 31 index was treading in the 78 bps spread area.

“We think that in 2019 corporate bond returns will be driven more by credit spreads rather than interest rates,” BNP Paribas Securities Corp. analysts said in a research report. “Poor 2018 performance was driven by a combination of higher yields and idiosyncratic factors. However, we expect 2019 corporate bond returns to be dominated by credit fundamentals.”

In 2019, spreads should underperform in the front-end in one- to three-year issues on the back of slowing unhedged foreign inflows and the belly of the curve in seven- to 10-year notes on lackluster inflows to bond funds/ETFs, the BofA Merrill Lynch analysts said. The back end of the bond curve is forecast to outperform on strong pension demand.

Financials are expected to outperform non-financials after trading slightly wider in 2018, JPMorgan said.

“We expect the BBB-A rated spread relationship to widen by 22 [bps] to 80 [bps], and the BBs to outperform BBBs by 22 [bps] to 130 [bps],” the analysts noted. “We expect BB bonds to trade sideways while we expect BBB bonds to widen.”

Corporate spreads ended December 2017 at 72 bps for A-rated industrials and 130 bps for BBB-rated industrials, the BofA Merrill Lynch report said.

By December 2018, A-rated industrial spreads had softened to 104 bps and BBB-industrials had widened to 184 bps.

However, the space has been impacted by a large migration of A-rated bonds to the BBB-rated category, the analysts said.

Libor yield climbs

Meanwhile, Libor may be discontinued in coming years, but it “is going out with a bang,” BofA Merrill Lynch said.

At the beginning of 2018, the three-month Libor yield touched 1.69%, the highest yield at that point since December 2008. By the end of 2018, the Libor yield was at 2.78% and is projected to hit 3.8% by the end of 2019, market sources report.

“We think Libor and tightening financial conditions are going to push USD corporate yields much higher relative to non-USD corporate yields,” the BofA Merrill Lynch analysts said. “We expect orderly credit spread widening in 2019, brought about by gradual increases in Libor as the Fed hikes rates.”

At least six deals were priced in 2018 using the Secured Overnight Financing Rate, a new benchmark that may be used to replace Libor, which is expected to be phased out by 2021.

The European Investment Bank (Aaa/AAA/AAA) priced the most recent deal with a $1 billion offering of global floating-rate notes due Oct. 8, 2021 placed at SOFR plus 32 bps on Nov. 28.

Fannie Mae priced a $5 billion offering of floating-rate corporate notes on Oct. 25 in three tranches in its second deal brought to the market in 2018 based on SOFR.

The offering saw demand of more than $18 billion.

Fannie Mae said in a press release following the deal that since its initial transaction in July, “there has been significant momentum in the SOFR market for floating-rate securities, including S&P’s confirmation of SOFR as an anchor rate for S&P-rated money market funds, the Federal Reserve’s announcement that enables issuers to shorten the lockout period ahead of coupon payments for some floating-rate securities to two days and additional SOFR transactions from a variety of issuers.”

In addition to EIB’s transaction and Fannie Mae’s two deals, Wells Fargo Bank NA sold $1 billion of floating-rate notes due March 25, 2020 at SOFR plus 48 bps on Sept. 18.

Other bonds issued with the benchmark in 2018 included Metropolitan Life Global Funding I’s $1 billion of two-year floating-rate notes priced on Aug. 30 at a spread of 57 bps over SOFR and the International Bank for Reconstruction and Development’s $1 billion of two-year floating-rate notes priced on Aug. 14 at SOFR plus 22 bps.

Issues mixed in secondary

The year saw a number of major corporate bond deals, including CVS Health Corp.’s $40 billion nine-part offering of senior notes (Baa2/BBB+) that priced on March 6, 2018. The transaction was the largest of the year and the third biggest high-grade deal on record.

New issues have been mixed in the secondary market, and a number of bonds were ending 2018 much wider than issuance, sources report.

CVS Health’s notes were among the exception and traded slightly tighter in late 2018. Moody’s Investors Service dropped the Woonsocket, R.I., retail pharmacy chain and pharmacy benefits manager’s ratings a notch in November based on factors including that its $69 billion cash and stock acquisition of Aetna, Inc. was financed with a large amount of debt.

CVS Health’s 4.3% senior notes due March 25, 2028 traded on Nov. 29 at 156 bps bid.

The notes priced in a $9 billion tranche in the March 6 sale at a spread of Treasuries plus 160 bps.

The company’s 5.05% notes due March 25, 2048 were trading at 192 bps bid on Nov. 29.

CVS Health sold $8 billion of the notes at a Treasuries plus 195 bps spread.

Meanwhile, Bayer AG’s notes that priced through issuer Bayer US Finance II LLC have widened more than 40 bps since pricing in June.

The company’s 4.375% notes due Dec. 15, 2028 traded at 199 bps bid as 2018 closed.

Bayer priced the $3.5 billion tranche of 10-year notes in a June 18 offering at a Treasuries plus 155 bps spread.

Dollar Tree Inc.’s senior notes (Baa3/BBB-) also moved out in secondary trading. The company’s 4.2% notes due May 15, 2028 widened to 208 bps bid by early December.

The Chesapeake, Va.-based discount retailer sold $1.25 billion of the notes on April 5, 2018 at a spread of 140 bps over Treasuries.

Dollar General Corp.’s 4.125% senior notes due May 1, 2028 (Baa2/BBB) were quoted at 178 bps bid in secondary trading in early December. The Goodlettsville, Tenn.-based retailer sold $500 million of the notes on March 26, 2018 at a spread of 130 bps over Treasuries.

Looking forward, Pacific Gas & Electric Co.’s senior notes (Baa2/BBB-/BBB-) are expected to remain under pressure in 2019 after the company’s power lines were linked to the California Camp Fire and its bonds downgraded in November, sources said.

“Credit is like stocks – there are high beta and low beta ones,” the BofA Merrill Lynch analysts said. “When overall market spreads tighten, high beta names tend to tighten more basis points than low beta names. Conversely in a spread widening environment – like this year – we should expect high beta names to widen more than low beta names.”

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