July 2016 was yet another month characterised by the reach for yield. Bank of America Merrill Lynch’s July 2016 monthly high-grade credit research note points out that year-to-date the excess returns for lower rated corporate bonds are as high as 3.67% or nearly three times the 1.23% performance recorded for the higher rated corporates.
This year’s reach for yield has been unlike anything seen for the past decade. Since 2004 there has not been another seven-month period when BBB rated bonds have produced excess returns of at least 3% and outperformed higher rated bonds similarly.
Still, despite the impressive July performance of lower rated corporate bonds, equities were the best-performing asset class of the month returning 3.69% (S&P 500), followed by high-yield at 2.53%, high grade at 1.45% and Treasuries at 0.42%.
Rather surprisingly the best performing high-grade credit sector last month was Metals & Mining. Credit spreads tightened by 282 basis points for the industry during July. Diversified Media (+175bps) and Multi-line insurance were the second and third best-performing sectors for the month. The Oil & Gas sector was, unsurprisingly, the worst performing sector with excess returns of 46bps as oil prices continue to decline.
Overall the high-grade credit market has erased most of its post-Brexit wobble. High-grade credit spreads tightened 13 bps in July to 150 bps, retracing June’s post-Brexit widening for excess returns of 98 bps.
Corporate debt will start to fall next year
High-grade supply remains robust as it seems that corporates are looking to take advantage of record low rates to increase leverage.
High-grade new issuance supply volumes totalled $96 billion during July, up from the $86 billion priced in June. While this amount was below the $174 billion of issuance reported for May, Bank of America’s credit analysts believe that with demand for yield robust and yields hovering near the cycle lows, there could be a sudden rush of issuance in August as companies frontload issuance plans to take advantage of the current environment. The bank is forecasting August supply volumes of $70 billion, up from the $50 billion previously expected. Last year, $49 billion of high-grade supply market. For the full-year 2016, Bank of America is forecasting $1.2 trillion of high-grade supply.
However, next year Bank of America’s credit analysts see issuance falling as corporates begin to repair balance sheets:
“A key pillar of our outlook for 2016 was that equity investors eventually get what they ask for and they are asking companies to stop adding leverage. We see this playing out in 1Q this year as the sum of buyback and acquisition volumes finally declined, a trend we expect to continue which eventually – as we have worked our way through the pipeline of M&A deals that have been announced but have yet to close – leads to lower leverage on HG corporate balance sheets. Fundamental erosion was a 2015 story – 2016 spells stability and 2017 improvement. That we find is a much more bullish view on fundamentals than the bearish consensus among investors.” — Bank of America Merril Lynch