Curb Your Enthusiasm: Analysts See Muted 2018 Credit Returns

(Bloomberg) -- The easy-money days are coming to an end, Wall Street credit strategists say. And they mean it this time.

After an unprecedented run, where clipping junk-bond coupons has meant annualized returns of 13 percent since the end of 2008, the tone’s about to change, according to the outlooks of strategists at six U.S. and European banks.

No one’s predicting a credit Armageddon, and the good times could keep rolling for a bit longer. But with the Federal Reserve raising interest rates and shrinking its $4.5 trillion balance sheet and the European Central Bank starting to trim its asset purchases, 2018 is likely to be the year that the tide starts receding, they say.

What will that mean for returns next year? JPMorgan Chase & Co. sees total returns paring to 2 percent in investment-grade U.S. credit and 5.5 percent in high-yield. Bank of America Merrill Lynch is projecting a slightly better return of 2.2 percent for IG and 6.5 percent for junk bonds. Europe’s red-hot junk-bond market will churn out just a 4.5 percent gain next year, Bank of America says. And UBS AG is projecting that Asia’s investment-grade market will produce 1.3 percent returns and 5.1 percent for high-yield.

“We probably will not see record-level type returns, but returns should nonetheless be steady absent any external shocks,” Howard Lanser, head of the global debt advisory practice at Robert W Baird & Co., said in an interview. With valuations at highs, any unforeseen catalyst in markets will be painful, he said. “The faster and higher you climb, the quicker and further you’re going to fall.”

Here are some of the Street’s return predictions for the U.S., Asia and Europe.

U.S.:

• JPMorgan’s analysts see “more of the same, but with higher risk.” They forecast foreign demand for U.S. investment grade bonds will decline as European Central Bank purchases fall, though they predict yields will stay above returns for sovereign and corporate issues outside the U.S. They are “constructive” on the riskier debt, but see more downside than upside risk, triggered by aggressive central bank policies.
• Bank of America’s team says that after a big rally in credit for the past two years, “we’re entering an environment similar to 2004-2007. The upside will likely be more limited, and technicals will become more challenging in the second half of the year,” the analysts said in their outlook report. They see risks to corporate debt if there’s no tax reform and a potential threat in increased foreign inflation.
• Morgan Stanley is predicting “significantly lower” U.S. returns in 2018, expecting a negative excess return of 1.4 percent for high-grade debt and minus 2.9 percent for riskier bonds. The lender sees late-cycle risks “popping up all over the place in the U.S.” with fundamental problems becoming more apparent in sectors as the Fed withdraws liquidity. “As is often the case near a top, these risks are being rationalized as purely idiosyncratic problems. We view them as fault lines that can expand quickly,” Morgan Stanley analysts said.
• Goldman Sachs Group Inc. is predicting modest-to-flat spread tightening. “With valuations at the tight-end of their historical range, the risk of a correction is elevated, though supportive macro fundamentals will likely limit the magnitude of the spread widening,” the strategists wrote.
• U.S. high-yield debt has returned 7.3 percent so far this year through Wednesday, while investment-grade has gained 6.2 percent, according to Bloomberg Barclays indexes.

Asia:

• Fading tailwinds of higher China import demand, strength in commodity prices and benign U.S. inflation that led to decent performance this year mean “we might not see a repeat,” according to UBS. They see headwinds as faster than expected U.S. rate hikes or faster slowdown in Chinese growth.
• JPMorgan sees low volatility and moderate spread tightening for investment-grade debt with return expectations of 3 percent to 3.5 percent in 2018.
• Asia high-grade debt has returned 1.9 percent in 2017, the data show.

Europe:

• Bank of America is cautious on companies in the periphery of Europe, given the big decline in quantitative easing from the ECB. The weight of central bank intervention on euro corporate bonds resulted in “anything but normal times for investors.” The analysts expect more European companies will leverage up balance sheets next year.
• JPMorgan sees supply-demand balance triggering market indigestion, and some spread widening in investment-grade credit. For high yield, the analysts see investor demand waning as ECB purchases slow, noting that the asset class has become more sensitive to future interest rate volatility. They see a small pullback as likely and forecast a 1 percent total return for high-yield and 3.5 percent for loans.
• Morgan Stanley is predicting a “partial reversal’ of the gains of 2017, seeing a negative excess return of 0.1 percent for investment-grade and minus 0.8 percent for junk. It notes that improvement in European credit fundamentals is not uniform, particularly in the high-yield market, with about 20 percent to 30 percent of 115 issuers in its universe not seeing improvement in their coverage ratios or leverage despite easy financing conditions.
• Wells Fargo & Co. strategists say negative total and excess returns are a “likely consequence” of the ECB’s corporate-bond purchase program’s demise in the second half. The analysts at Wells Fargo Securities are “not enthused by any” euro investment-grade valuation metric at the moment.
• Junk debt has in Europe climbed about 6.4 percent this year, while investment-grade is up about 2.5 percent.

--With assistance from Lisa Abramowicz Claire Boston and Kenneth Pringle

To contact the reporter on this story: Sally Bakewell in New York at sbakewell1@bloomberg.net.

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Dan Wilchins

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