Here’s One Reason to Be Bullish on U.S. High-Grade Debt in 2017

(Bloomberg) -- As rocketing outflows from a clutch of exchange-traded bond funds this week betray anxieties that valuations in credit markets may be stretched, Bank of America Merrill Lynch analysts offer a quantum of solace for high-grade investors. 

Fresh issues of U.S. investment-grade bonds next year will be comfortably absorbed by markets as investors are set to become cash-rich and supply volumes stage a modest fall, they say. 

That's a notable shift in market technicals that should also help to keep credit spreads in check, the strategists at the U.S. bank reckon. Their projections temper fears that a repricing in U.S. rates might roil credit markets in 2017, in the wake of October's sovereign-bond rout and rising expectations of a Fed rate hike in December.

Net supply of new U.S. high-grade debt will decline by 31 percent to $511 billion thanks to a rise in maturing debt and coupon payments that will boost investor firepower to soak up what Bank of America estimates will be $1.15 trillion of high-grade bond issuance in 2017.

"In a big shift from the past several years the high-grade market becomes roughly balanced internally, a sharp improvement from about $200 billion in annual cash needs in earlier years," the Bank of America analysts, led by Hans Mikkelsen, wrote in a report last week. "That supports our bullish outlook for credit spreads."

The analysts forecast gross volumes of new issuance will decline 10 percent next year from an expected $1.28 trillion in 2016, as a reduction in debt-financed share buybacks and lower acquisition-funding needs offset an uptick in bonds issued to finance capital expenditure.

"For over 10 years cash needs related to acquisition and share buybacks have largely determined incremental borrowing of U.S. high grade issuers. In particular issuance was driven higher by an increase in share buybacks in 2014 and then by a jump in acquisition volumes in 2015 and 2016," the analysts write. "Now we look for a decline in such re-leveraging activities leading to lower high grade borrowing needs in 2017."

Favorable funding conditions in Europe, amid a central-bank-induced credit rally, is another reason why analysts foresee a reduction in investment-grade dollar bond supply next year, as European and U.S. companies are expected to continue their headlong rush into the single-currency bloc's primary market. 

The strategists estimate maturing debt volumes, or amortizations, will see a 10 percent year-on-year jump to $636 billion next year, and foresee a notable rise in coupon payments. Both factors, therefore, will boost the cash available for portfolio managers seeking to put their money to work in the primary market next year. 

These positive technicals paint a partial picture of investor firepower next year; new money pouring into the asset class would further boost their ammunition. 

While flows into dollar bond funds have softened in recent weeks, strong international interest in dollar fixed-income markets and the relatively benign impact of rising U.S. rates on high-grade credit markets should continue to buttress flows, Mikkelsen and team conclude.

"Let us be clear that the recent increase in long term interest rates is a good increase for credit spreads, as it comes without elevated rates volatility. A lot of (yield sensitive in the traditional sense) credit investors have been relatively defensively positioned as yields collapsed, waiting for higher rates."

To contact the author of this story: Sid Verma in London at sverma100@bloomberg.net.

To contact the editor responsible for this story: Isobel Finkel at ifinkel1@bloomberg.net, Lorcan Roche Kelly