Signed, yield, delivered?

It’s no secret that 2022 was tough for markets. Alongside a general rout in equities, the S&P Eurozone Investment Grade Corporate Bond Index lost -12.83%[1]; it was even worse for riskier high yield assets.

However, this brutal punishment has resulted in the highest yields for two decades.

At the beginning of 2022, euro area corporate bonds yielded about 0.5%[2]; by  October we were blogging about yields as high as 4.25% and arguing there was a compelling longer-term valuation argument for euro investment grade credit.

At the same time, we pointed to wider economic uncertainties in Europe created by the energy crisis, and unprecedented volatility in fixed income assets as inflation reached levels not seen for decades.

With the passing of winter without any blackouts and the significant drop in gas prices, the spread differentials of euro and USD credit indices versus government bonds have converged back to around 30 basis points (bps), having been as wide as 80bps at the end of October last year[3].

These yields have not kept pace with inflation across Europe, of course, but it is still remarkable that investors now receive as much holding investment grade debt as they recently received for high yield.

We’ve also pointed out that the limited duration of euro credit provided some protection against uncertainty in rates. We used the MOVE index, which captures the option premium traders charge for hedging interest rate risk in the US Treasury market, to capture this uncertainty. It shows how this premium has come down, which also fed into lower credit spreads, while at the same time government bond yields have hardly come down since inflation proved very persistent.

At around 145bps, investment grade euro credit spreads are close to their longer-term historical average going back to December 2006. If we look at the historical ranking of spread valuations since 2006, a period covering many crises, they are now in the 60th percentile. This means that over the past 16 years, spreads have been at this or wider levels for only 40% of the time.

Will Goldilocks stick around?

Whereas government bond yields are persistently high and, after a short-lived rally at the start of the year, back above their levels at the end of last year, credit spreads have rallied strongly.

While much of last year was dominated by gloomy outlooks, it now appears that the conditions at the end of October last year were just right to deliver a large rally in European credit. In the three months to February 14, the ICE BofA Euro Corporate Index returned a solid 3% versus a negative return on German government bonds of a similar duration[4].

The comparatively attractive spread and total yield, combined with the relatively high credit quality of the asset class, attracted strong inflows, supporting prices and pushing down credit spreads. At the same time, the substantially reduced probability of recession has supported risk assets in Europe in both fixed income and equity. The European Commission now forecasts the euro area to grow 0.9% this year, a substantial revision upward of the 0.3% of growth it previously anticipated[5].

Can these ‘just right’ conditions persist?

 Charting the year ahead for European fixed income

At the time of writing, spreads still compare favourably with their longer-term averages, but the rally has made us more cautious on current valuations. We need to put them in the context of tightening monetary conditions, still elevated energy prices and geopolitical uncertainty.

The key variable going forward is the timing and scale of further rate hikes, which in turn will be determined by the changing prognosis for a potential European recession. We believe current yields of over 4.2%[6] will provide something of a buffer against further rate rises, since due to positive carry this yield would need to go up by more than 1.25% over a 12-month period before total returns turn negative.

In any case, rate risk is relatively manageable thanks to the duration of European credit investment grade – around 4.5, compared with durations of around two years longer for the USD and GBP markets.

Quantitative tightening represents another variable. The European Central Bank (ECB) is set to reduce its asset purchases, and from next March plans to only reinvest half of the amount that comes due from maturing bonds. ECB bond purchases have been a substantial support for the market. As inflation continues to be well above target these are expected to fall from a peak of over €6bn at the peak in 2021 to €1-2bn, and may be abolished completely by the end of June.[7]

When put in this context current Euro credit spreads are well below the levels we witnessed in earlier periods of monetary tightening, like the second half of 2018.

In conclusion, we continue to be constructive on European investment grade credit from the perspective of longer-term valuations and yields. At the same time, we believe there are multiple challenges ahead, which make us more cautious in the short term as, following the recent rally, there is less of a buffer in valuations.

From a portfolio management perspective, we express this by adopting a more conservative positioning that focuses on issuers where our credit analysts believe they can withstand a recession without facing multiple downgrades. We continue to underweight cyclicals and bonds that are impacted by the reduction in the ECB’s corporate bond buying.

We prefer lower-cash-price bonds for lower-quality bonds, as this can typically provide some downward protection, and continue to manage for liquidity where we limit holdings in issues that are more difficult to trade as this enables us to adjust our portfolios while limiting transaction costs.

[1] Source: Bloomberg as at 13 March 2023

[2] Source: Bloomberg as at 13 March 2023

[3] Source: Bloomberg as at 13 March 2023

[4] Source: Bloomberg as at 13 March

[5] Paolo Gentiloni speech, 13 February 2023

[6] Source: Bloomberg as at 22 February 2023

[7] Source: as per latest ECB press conference