Bank of America Merrill Lynch Global Research Outlook on Credit Spreads and AT1s (Nov 2016)

Healthcare’s forward PE is now down to just a 7% premium relative to the market and nearing the valuation lows recorded in 2010-12 when the patent cliff was at its worst and pipelines were very weak. Today pipelines are twice the size they were in 2011 and innovation is the key to growth in the sector - pricing power remains strong in drug categories with differentiated products. Credit: Long Spreads in Europe and US Europe: Long Xover short Main Rate cuts are off the table it seems, as central banks are starting to recognise the side effects of NIRP. This reinforces our view that a continuation of CSPP, entails that the reach for yield will extend to those assets that have not seen it yet; long Crossover vs iTraxx Main. The beta outperformance has already started in the cash market. We look at synthetics and we see that Crossover has not mirrored that performance. Even though XO has outperformed recently, it still has further to go to close the gap vs cash market’s performance. loannis Angelakis thinks that rising political risks in the following twelve months are more likely to weigh on iTraxx Main performance than Crossover, as Main has higher concentration vs XO on names domiciled in countries with elections. Buy 30y US IG Industrial spreads US high-grade is the market our colleagues in Credit Strategy are most bullish into 2017. Hans Mikkelsen thinks IG corporate spread maturity curves super-flatten as global credit investors do the twist - i.e. sell shorter maturities and buy the long end. Foreign inflows are now concentrated in the back-end, as credit spreads have rallied while the cost of currency hedging increased. That means that only the back end of the steep US corporate spread curve offers enough spread to overcome the high cost of currency hedging. The flip side is that the front end of the US credit spread curve is very unattractive and we expect domestic and foreign investors to accelerate their selling of shorter maturity US corporate bonds. Overall, Hans expects the 30yr corporate bond part of the market to generate 8%-9% total returns next year. Chart 38: High grade spread forecast Chart 39: High grade returns forecast 290 6.0 2.0 0.0 -2.0 so S © S SB A KH A A er Ww Se ev NS & Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Long AT1s basket Contingent capital continues to offer a compelling premium to European HY and lower volatility than bank equity. The asset class also received a boost last week when the European Commission submitted a proposal for AT1 coupons to be prioritized over common dividends and bonuses if the bank breaches its combined buffer. This placates one of the main concerns investors have, i.e. that banks could decide to skip a coupon payment but maintain their dividend. The confirmation of the role of AT1s in Pillar 2 capital is another example of regulators providing clarity on how contingent capital fits within the overall capital structure. The main short term risk for the trade is the fate of the Italian banks recap, so we will be watching closely to see how that develops. HG Spread (bps) ——#— Forecast wExcess Return (%) = Total Return (%) 5.2 20 Global Cross Asset Strategy - Year Ahead | 30 November 2016 BankofAmerica <2” Merrill Lynch HOUSE_OVERSIGHT_014451