Corporate Bond Investors Are Waiting for Bargains in 2019
(Bloomberg) -- Company debt got whacked in 2018. Some money managers and strategists are gearing up to go bargain hunting next year.
The huge question marks that have hung over corporate profits for much of the year are still around: The U.S. and China are brawling over tariffs. The Federal Reserve expects to keep tightening rates, announcing plans on Wednesday to hike twice next year. The European Central Bank is stopping its bond purchase program. A no-deal Brexit looms over the U.K., while Italy is planning to slash government spending as it struggles to rein in its deficit.
But with U.S. investment-grade corporate bonds having lost 2.6 percent this year, even after interest payments, the securities are offering some of their highest yields since 2010. Prices for new-issue leveraged loans have reached their lowest levels in more than two years.
“There are going to be pockets where things trade down to less than rational levels,” said Stephen Philipson, head of fixed income and capital markets at US Bancorp. “There will be a lot more opportunities in 2019 from a returns perspective,” compared to the last decade, he said.
Here’s how money managers and strategists are suggesting investors position in 2019:
BBBs: Bye or Buy?
There’s now around $2.5 trillion of U.S. corporate debt rated in the BBB tier, more than triple the level at the end of 2008. The block of securities, dubbed “bad boy bonds” by one group of strategists, now account for about half of investment-grade company securities. Morgan Stanley strategists last month said that if spreads on these notes widen by 0.1 percentage point, U.S. economic growth could slow 0.3 percentage point and unemployment could rise.
That fear is creating opportunities, according to strategists at Bank of America Corp. and Wells Fargo & Co. They think that investors should take advantage of the recent weakness and buy BBBs, which could benefit from lower bond issuance and improving credit fundamentals in 2019.
Strategists at Goldman Sachs Group Inc. and Barclays Plc are more concerned about credits rated in the segment just above BBBs, the As. Those credits can get hit harder when downgraded to BBB than bonds that get cut to junk.
Leveraged Loans -- as scary as they look?
Loans to junk-rated companies were the best performing asset class in U.S. fixed income this year as the Fed lifted rates and investors sought floating-rate debt. Posting gains that stood at more than 4 percent just two months ago, the riskier corporate debt has now surrendered most of it amid a series a record outflows.
Next year will be even tougher -- the biggest buyers of company loans, money managers who repackage the borrowings into securities known as collateralized loan obligations, have been slowing down. And with the Fed more dovish, investors are less interested in stocking up on loans. If the U.S. central bank only hikes twice in 2019, leveraged loans could return 4.5 percent, compared with a 6.25 percent return for high-yield bonds, JPMorgan strategists led by Peter Acciavatti said in a Dec. 6 note.
Credit Brief: Banks are increasingly stuck with loans they can’t sell
Loan prices have fallen enough, particularly relative to junk bonds, to draw demand from investors like Allianz. If the Fed ends up staying aggressive next year, Bank of America and JPMorgan Chase & Co. still like loans over high-yield bonds.
M&A Moves Away
Rising funding costs and global macro uncertainties could slow the pace of corporate mergers and acquisitions in 2019, and along with it the debt needed to fund these transactions. “The worst thing for M&A is uncertainty,” Bob Saada, PwC’s head of U.S. deals, said on Bloomberg TV this week.
All in all, gross supply in the high-grade market will probably fall in 2019, according to Bank of America, JPMorgan, Morgan Stanley and Wells Fargo, which should provide technical support for a market that faces some headwinds.
China vs. U.S. -- What Next?
Trade talks between the U.S. and China will be a key factor in how fast the economy grows and what happens to markets. Weaker demand from China and the anticipation of further tariffs will probably weigh on earnings outlooks in the coming months, especially for cyclical sectors, according to Commerzbank AG.
Other sectors that could be vulnerable to trade tensions include autos in U.S. investment-grade credit, and retail in high-yield, according to Goldman Sachs, which rates both sectors as underweight. Bank of America is cautious on autos, industrials and technology.
In European credit, JPMorgan hedges against a further escalation of the tensions by avoiding sectors such as building materials and capital goods, while Danske Bank recommends going underweight airlines as the geopolitical dispute might impact their earnings.
China: Is the worst over for debt defaults?
Bond delinquencies in the world’s second largest economy almost quadrupled this year to 108 billion yuan ($15.7 billion), fueled by a campaign to shrink the nation’s shadow financing. Although authorities have eased policy since July, the problem is far from over as China faces elevated borrowing costs, a large upcoming maturity wall and a slowing economy, according to S&P Global Ratings.
S&P warns that miners along with oil and gas drillers may face liquidity pressure as energy and commodity prices drop. Small property developers could also be vulnerable given a sales slump and refinancing risks, S&P said.
Bonds from local government financing vehicles may be worth buying next year because authorities plan to derisk the sector, increasing the securities’ value, according to Li Yishuo, Beijing-based portfolio manager at E Fund Management Co. The asset manager’s two bond funds beat more than 90 percent of their peers this year, according to Bloomberg-compiled data.
UBS sees a hard Brexit as “the most material downside risk for EU credit.” The market is unprepared for a hard Brexit as the U.K.’s return to World Trade Organization rules would cause “considerable pain” from an increase in tariffs and non-tariff frictions such as customs checks, Barclays wrote.
Yet BNP Paribas sees Brexit risks priced more symmetrically now, saying that “for the first time this year the market is no longer complacent about the downside risks.” That said, BNP strategists also see a higher likelihood of extreme outcomes, with a no-deal outcome likely pushing spreads to recession levels.
Who’ll Miss the ECB?
The end of the ECB’s corporate bond purchases will probably translate into bigger price movements in the debt and wider spreads, according to Morgan Stanley, but some companies will suffer more than others, and there won’t likely be a broad-based corporate funding shock, the bank said.
Company issuance will likely be relatively stable, Danske Bank said, but the ECB won’t be in the primary market anymore. That should help push euro investment-grade spreads wider by about 0.1 percent point, and high-yield spreads wider by about 0.3 percentage point, the bank forecasts. For many corporate bond issuers facing wider spreads, the loan market will be a cheaper alternative, according to UniCredit SpA.
©2018 Bloomberg L.P.