The strengthening economy has stoked demand for high-grade corporate bonds, dropping the spread on investment-grade debt to levels last seen before the financial crisis.
Demand for the bonds has been insatiable in 2017, with investors seeking out higher-quality securities during what may be the late stages of the credit cycle. Overseas investors made up a big chunk of that, hunting for higher-yielding assets than those found in domestic markets in Europe and Asia.
The spread on investment-grade debt narrowed to 93 basis points as of Tuesday’s close, the lowest since 2007 when the spread hit 82. It started this year at 122 basis points. Junk bond spreads are also tight, though they remain a touch wider than levels last seen in October.
Spreads have been narrower before. The high-grade spread hit 76 in March 2005, and tightened to 51 back in 1997, for the lowest since 1989.
In the years after the financial crisis, credit spreads were depressed by easy Federal Reserve policy, robust company health and firm investor inflows. That’s continued this year, according to Nicholas Elfner, director of corporate-bond research at Breckinridge Capital Advisors, who also cited growing corporate profits, a healthy U.S. banking system, and strong flows from domestic and foreign investors, including life insurance companies.
“These positives outweighed rising geo-political risks, cyber-security breaches and record-high leverage in the industrial sector,” he said.
Such voracious appetite for the debt has made 2017 the second consecutive year of rising bond supply and deal volume. Global corporate investment-grade issuance topped $2.2 trillion this year between nearly 8,300 debt sales, as companies took advantage of low global interest rates.
But the spread tightening may not have so much further to run.
While strategists at Wells Fargo & Co. forecast dollar-denominated high-grade spreads will grind “marginally tighter” in early 2018, they expect to end next year with spreads 15 basis points wider.
Tighter monetary policy in Europe and possibly Asia could weigh on premiums, together with debt-fueled merger-and-acquisition activity that sparks a more volatile second half of the year, Wells Fargo strategists said. Fed policy will be a 2018 headwind, according to Morgan Stanley, which forecast a negative 1.4% excess return for investment-grade credit in 2018.
—With assistance from Dan Wilchins.
—Read Gundlach: Tax Cut Timing Is ‘Strange’ and ‘Bond-Unfriendly’ on ThinkAdvisor.