Credit : Merrill Lynch cautiously optimistic for 2018

2017 has been a pretty good year for credit investors so far, and this might continue providing inflation doesn’t accelerate too much, according to Bank of America Merrill Lynch credit strategists.

« For 2018, the big bullish theme for credit markets will be a scarcity of bonds, in our view »write Barnaby Martin and team in a report dated Nov 21. After a good year for both IG and HY markets, 2018 could prove another reasonable positive returns, thanks in part to the pursue of central banks accommodative policies, despite the fact that the Fed is going to continue tightening, with 3 rate hikes and 100 bp expected by Merrill Lynch economist.

In terms of geographies positioning, there is a relative preference for the US, where spreads might still offer some upside potential, even thought they are historically low.

« Relatively, we are most constructive on US high-yield (+6.5% total returns) where easy monetary policy should help the default rate drop again. US high-grade (+2.2% total returns) will likely offer a year of two halves, but tax reform should underpin a first half rally. In Europe, negative rates and ECB corporate QE are proving to be overwhelming tailwinds (+1.5% IG total returns and +4.5% HY total returns). And in Asia (+5.4% HY total returns) improving fundamentals should help spreads compress further. »

So where do they see value in the current environment ?

Here’s the recap from the team for trade ideas for 2018 :

« In US high-grade, we think the big story will again be a flattening of non-financial cash bond curves, with 5s30s the sweet spot this time. We are cautious on front-end corporate bonds (repatriation victim) and high-quality credit (Quantitative Tightening victim). But we would be overweight the tech sector (repatriation beneficiary) and telecoms (foreign buying).

In US high-yield, we would overweight lower quality and long duration paper. We also prefer to be long high-yield cash bonds over synthetics. We expect leveraged loans to also tighten significantly next year.

In Europe, we see another year of spread compression playing out, given ongoing corporate bond QE and very low levels of rate volatility. That means BBBs, corporate hybrids and sub financials are again likely to perform better than the market. We prefer « domestics » over « exporters » but are wary of peripheral credits in 2018. In high-yield, we think the sweet spot will be BBs given the record trend in credit rating upgrades.

In Asia, we prefer As over BBBs, and especially like Chinese technology bonds. In high-yield, we like select short-dated single-Bs, and we see China industrials and Indian HY as having the best tailwinds. In EM corporates, we expect LatAmnames to tighten the most in both high-grade and high-yield.

In Derivatives, we like selling the vol skew to extract alpha. In the US, we like buying S&P puts vs. selling CDX HY puts as a hedge for tax reform uncertainty. In Europe, given the rise in idiosyncratic risk, we like owning senior iTraxx tranches. »

A couple of interesting charts from the long and comprehensive report.

Well the first 2 ones are the most impressive, since it shows how yield has disappeared in fixed income.

Source: Bank of America Merrill Lynch

Other interesting charts revolve around QE and when the monetary policies of DM central banks will stop support financial assets on a global basis

The end of QE could mean widening spreads in US IG and HY during the second half of 2018.

US High Grade

Expected return: +2.2% (2018e)

Key drivers: credit spreads tighten in the first half (excess demand), then widen in H2 due to the end of QE, but not wide changes. Credit spreads expected around 100 bps over 2018 (from 106 bps now to 95 bps mid-2018, then back to 100 bps end-2018).

Leverage is elevated and expectations for corporate profits are modestly positive, with a potential impact from US corporate tax reform. Overall, leverage should remain stable, but high.

Key ideas : Prefer banks and TMT sectors and underweight consumer.

US High Yield

Expected return: +6.5%

Key drivers : credit spreads tightening from 380 bps to 290 bps, which would give a 365 bps return from spreads, mitigated by -231 bps from rates. Yield should provide 641 bps, while credit loss is estimated at 128 bps.

Fundamentals/valuation : despite spreads tightening over the last few years, ML expects this trend to continue into 2018. As a reminder, the record low in US HY spreads is 250 bps, which occured in mid-2007 and late 1997.

Europe Investment Grade

Expected return :+1-1.5%

Key drivers : central banks should be the main driver, while credit spread tightening should be limited (10-15 bps expected). Volatility could stay low. Technicals, specifically a drop in paper supply in the magnitude of 10% compared to 2017 issuance, could also support the market.

Source: Bank of America Merrill Lynch

Fundamentals/valuation : valuation are getting more and more stretched, with a clear risk of bubble for the asset class.

Europe High Yield

Expected return :+4.5%

Key drivers : Lack of alternatives for yield. Credit spread tightening should be limited (50-75 bps expected). Fundamentals should improve (especially BBs rather than single-Bs), with more upgrades than downgrades. Default rates should stay low in Europe (1-1.5%). Technicals should be supportive as well, with more demand than supply for European high-yield, assuming no big outflows.

« We do not see a major change in direction for European high yield spreads for the upcoming year. As we believe the ECB will continue dampening volatility and favouring private sector purchases for the remainder of the APP life, higher yielding assets stand to perform better than their IG peers. We think this bodes well for corporate hybrids, sub financials and high yield bonds. »

Asia Credit

Expected returns :+2.2% for Asia Credit ; +1.5% for Investment Grade ; +5.4% for High Yield.

Key drivers : Fundamentals should continue improving, after a decent 2017 marked by higher commodity prices. Macro backdrop should also be supportive for the asset class.

From ML’s report :

«  We expect Asia IG companies to sustain stable revenue growth, and capex and M&A to remain at a manageable pace, which together should lead to a stable leverage. In addition, Chinese IG corporate will likely witness fundamental improvement, given continuing regulatory efforts in de-leveraging.

Meanwhile, overall, we expect HY leverage to trend up slightly, driven by Chinese HY property’s aggressive land banking and potential slowdown in contracted sales after a strong year in 2017. However, we do not expect the impact on leverage to be extensive, as companies that can issue USD bonds are already stronger developers with more market share in China amid the market consolidation trend. For other HY industrial credit, with cost and capex control being implemented continually, and given the strong commodity price outlook, we expect a stable outlook in top-line and credit fundamentals. As a result, overall, we see a decent fundamental picture for both IG and HY in 2018. »

Spreads should tighten 11 bps in IG and 28 bps in HY in 2018 (base case). IG spreads could widen at the beginning of the year due to rate hikes, yet would tighten afterwards once rates stabilize. Supply should be in excess of demand, mainly because of China (greater access to the offshore market for Chinese issuers).

Key risks : USD and higher interest rates (sharp increase) could bring about vulnerabilities in the asset class.

Positioning : Merrill Lynch’s strategist see better value in single-As than in BBBs (5 year tights). In HY, the bank prefers single-Bs to BBs.

EM debt

Expected returns : +1.9% for Investment Grade ; +5.4% for High Yield.

« Our baseline forecasts call for EM IG spreads to tighten -11 bps (to 130bps) and EM HY spreads to tighten -39 bps (to 370bps). Given BofAML’s U.S. interest rate forecasts (2.65% 5yr; 2.90% 10yr), this leaves us with overall EM corporate total returns of 3.2% for 2018. By region, we expect total returns of 4.7% for LatAm, 3.7% for EEMEA and 2.2% for Asia. »

Drivers : Technicals and fundamentals should drive spreads tigher, with the most coming from LatAm. Overall, EM spreads should tighten thanks to lower default rates, slow unwind of central banks’ asset purchases.