Outlook 2018: High-grade bond supply to decline on tax cut; 2017 finishes with record volume

By Cristal Cody

Tupelo, Miss., Dec. 29 – Investment-grade bond issuance is projected to decline slightly in 2018 on the back of U.S. tax reform following record issuance of $1.41 trillion in 2017.

Market insiders expect supply for the year to drop anywhere from 10% to 17% due to the reduced 21% corporate tax rate that will make debt more expensive on an after-tax basis.

“We now expect a 17% decline in high-grade new issue supply volumes in 2018 to $1.18 [trillion],” Hans Mikkelsen, head of U.S. high grade strategy at BofA Merrill Lynch, said in a research note. “Due to an increase in bond maturities, we expect net supply to decline 34% to $530 [billion].”

Other syndicate sources peg the new year’s volume higher in the $1.3 trillion to $1.4 trillion area.

Morgan Stanley & Co. LLC analysts forecast a modest drop and expect about $1.4 trillion of investment-grade issuance in 2018.

Tax reform on the whole is expected to be positive for investment-grade credit quality, sources report.

Trillions of dollars of offshore funds are expected to repatriated back to domestic accounts.

Deal volume in corporates and sovereign issuance has climbed consecutively every year since 2012, said Ronald M. Quigley, head of fixed income syndicate, primary sales and FIG/utilities DCM at Mischler Financial Group, Inc.

By December 2017, high-grade deal volume totaled $1.41 trillion, a new record and 8% higher than 2016 volumes, according to Mikkelsen.

High-grade corporate issuance by mid-December was $1.33 trillion, up 3.75% from $1.29 trillion in the year-ago period, Quigley said.

The year “won out as the highest volume year on record for both IG Corporate and all-in IG Corporate + SSA new issuance.,” Quigley said. “This year’s IG corporate total beat last year by $48.138 [billion] or 3.75% more while all-in volume beat by $23.595 [billion] or 1.45%.”

Corporate and SSA issuance together totals about $1.65 trillion through Dec. 15, up from the $1.63 trillion priced through Dec. 15, 2016.

The deal pipeline is expected to be strong out of the gate in January with syndicate sources predicting about $125 billion to $150 billion of issuance in January.

January’s supply is expected to be dominated by banks, according to syndicate sources.

The major banks including Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc. and Wells Fargo & Co. all have January maturities due and earnings announcements scheduled for the first month of 2018.

New year’s supply

However, bank and financial primary action overall is expected to drop in 2018.

“We look for issuance to decline 23% for U.S. issuers, on the back of tax reform and a decline in bank issuance next year,” according to a BofA Merrill Lynch report.

Banks are expected to issue about $60 billion less paper in 2018 over 2017, Mikkelsen said.

The large banks started 2017 with a $75 billion debt shortfall related to the total loss absorbing capacity, or TLAC, regulatory requirement.

“Banks responded by accelerating issuance to $225 [billion] during the first 10 months of 2017, above the $163 [billion] average issuance pace for the same period in 2015 and 2016,” Mikkelsen said. “This has allowed them to address most of the TLAC shortfall. Hence, U.S. bank supply should now return to the more typical pace.”

Financial issuance is forecast to fall to $263 billion from $320 billion in 2017, according to BofA Merrill Lynch. Non-financial issuance is projected to decline to $475 billion, down from $633 billion in 2017.

Investment-grade bond volume is expected to decline due to several factors in 2018, including a drop in share buybacks and bond tenders.

Total volume is expected to see a decline of $16 billion from an estimated $28 billion decline in share buybacks in the new year, according to Mikkelsen.

“We estimate that 57% of share buyback expenditures are funded with debt,” he said.

Share buyback volumes declined 10% in 2016 with an estimated similar drop expected in 2017 and 2018, Mikkelsen said.

In addition, BofA Merrill Lynch expects the volume of bond calls and tenders to decline to $200 billion in 2018 from $247 billion in 2017 with the incentive to tender before tax reform gone.

M&A financing to rise

Merger and acquisition-related debt funding may see a gain over the year after declining in 2017, sources report.

Merger and acquisition-related issuance is forecast to rise by $9 billion, or 4%, “as we think uncertainty about tax reform contributed to a decline in M&A this past year, as animal spirits following the 2016 election gave way to an uncertain political year,” the Morgan Stanley analysts said.

Announced merger and acquisition deal volume fell to $184 billion in 2017 from $239 billion in 2016, according to BofA Merrill Lynch.

“As tax policy uncertainties are reduced next year, we think that may unleash some M&A activity,” Mikkelsen said. “Hence we look for the underlying pace of M&A in 2018 to remain similar to this year, but with the supply impact declining by $25 [billion] due to front-loading in 3Q.”

About $200 billion of merger and acquisition-related financing is expected for the year, Quigley said. Utility and FIG activity is expected to bring in about $50 billion of supply.

Refinancing high-grade bonds also is expected to increase in 2018.

Morgan Stanley forecasts high-grade refinancings to grow $39 billion to $697 billion “as IG bond maturities should rise another 6% next year from a record level in 2017.”

The biggest risks for the high-grade bond market in 2018 are foreign inflation picking up, the increasing cost of dollar hedging, macro shocks and releveraging event risk, according to BofA Merrill Lynch.

Record issuance in 2017

While the past year did not have record-sized individual deals, such as Anheuser-Busch InBev Finance Inc.’s $46 billion seven-part bond deal priced in 2016 that was the second-largest bond offering on record, several jumbo offerings came to the primary market.

AT&T Inc. priced $22.5 billion of senior notes in seven tranches on July 27 ahead of its expected acquisition of Time Warner Inc., which the Justice Department filed suit to stop and delayed the deal’s closure in 2017.

British American Tobacco plc’s BAT Capital Corp. priced $17.25 billion of senior notes in eight tranches on Aug. 8.

Those two deals contributed to 3% of the year’s volume, Quigley said.

Deal action was heaviest in January, May and September.

“Roughly 45% of 2017 IG Corporate issuance came in the months of January, May and September,” he said.

Much of the year’s issuance was front-loaded ahead of the September Federal Reserve monetary policy meeting when the Fed was widely expected to announce balance sheet reduction starting in October, Mikkelsen noted.

Amazon.com, Inc. priced its $16 billion seven-part offering of notes on Aug. 15 to fund its $13.7 billion acquisition of Whole Foods Market Inc.

Other issuers, including Apple Inc., Microsoft Corp. and Verizon Communications Inc., also brought major deals during the year.

“As we see consolidation taking place, the TMT sector impressed with issuers such as Apple, Microsoft, Amazon and Verizon totaling approximately 5.7% of this year’s issuance or just over $76 [billion],” Quigley said. “There seemed to be a lack of utility issuance in 2017 following the record utility M&A related issuances we saw in 2016.”

Of the year’s deals, about 9.5% of issuance came from five of the big U.S. banks – Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase & Co. and Morgan Stanley, he said.

Fixed-to-floaters eyed

“There was a notable trend on the part of the largest banks to issue fixed-to-floating rate debt,” Quigley said. “F-t-F bonds are designed to take advantage of a change in interest rates. The advantage of this structure is two-fold: First, it keeps the bonds from severe declines in price, and second, the coupon payments rise right along with short-term rates so that cash flows can also increase.”

Financial supply increased by $63 billion, or 12%, year over, while non-financial issuance was up $43 billion, or 6%, according to BofA Merrill Lynch.

Banks and technology issuers made up the bulk of the year’s supply.

The sectors that saw the most declines in issuance included food, beverage and bottling and health care.

Several reasons contributed to the year’s record-breaking issuance, including a historic low-rate environment with only three rate hikes in 2017, Quigley said.

Yuri Seliger, an analyst with BofA Merrill Lynch, said in a note that the increase in supply in 2017 compared to 2016 was driven by U.S. industrials, U.S. banks and non-European DM Yankee banks.

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