The case for Euro credit in three charts
2022 has been a turbulent year for credit markets. Have spreads now widened to the point where credit is an opportunity?
2022 will be remembered.
By economists, by investors, and by central bankers all over the world.
The mainstream press is awash with buzzwords such as ‘inflation’, ‘cost of living crisis’, ‘recession’, ‘war’, ‘rate hikes’, and – more recently – ‘paradigm shift’, and they are not easy to digest.
For bond investors, there is no doubt that 2022 has been challenging: the key 10Y German government bond yield has quadrupled this year to beyond the 1% level, while investment grade credit spreads have moved wider by over 0.5% – meaning negative returns.
We believe the key question now is whether current credit levels present an opportunity for investors.
To help us address this question, we share three key charts.
1: Euro credit spreads
So far this year, euro credit spreads versus German government bonds have moved to new highs rarely seen outside of a recessionary environment, as you can see in the chart below:
If we look at the historical ranking of spread valuations since 2006, a date which encompasses many crises, they are now in the 70th percentile. This means that over the last 16 years, spreads have been this wide for only 30% of the time.
Some sectors such as utilities, healthcare, oil and gas and consumer goods are even wider: close to the 80th percentile. With spreads on the Euro Corporate Index currently at over 1.60% versus German government bonds, we believe this should provide a cushion for further spread-widening.
In addition, euro credit also has a lower duration profile than its sterling or US dollar counterparts, which somewhat shields the asset class from further yield rises in government bonds.
If we define a recession as two consecutive quarters of negative growth, LGIM’s economics team now sees a 50/50 chance of recession in Europe by the middle of 2023.
We believe this challenging outlook has largely been priced in by the market, along with as many as three to four more rate increases by the European Central Bank this year.
2: Income from bonds: is 3% the magic number?
Yields on credit indices have risen steadily this year, reaching over 2% on the index level, as we can see below:
3: Historic excess returns
Euro spreads at their current levels have in the past offered an entry point for investors seeking excess returns.
Our analysis suggests that buying euro credit at the 70th percentile has historically resulted in excess returns of over 3% over the following 12 months.
If we expand the scope to 36 months, based on past returns our analysis points to per annum returns of well over 4%, as we can see below:
Source: LGIM analysis based on Bloomberg Euro Corporate Index monthly data from January 2010 to April 2022. Red colours show negative excess returns as the higher price you pay for an asset the less likely it is to gain in price from that point and green colours show positive excess returns. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.
As with any forward-looking analysis, we must point out that past performance is not a guide to the future, and there is no guarantee that these will come to pass. Long-term investors will remember that spreads can go wider form here particularly in period of crisis, stagflation and more monetary tightening to what's priced in and these are hard to predict.
Returning to the question posed at the start of this blog – our analysis leads us to believe spreads do, indeed, present a potential long-term opportunity. But one that is balanced by significant risks and uncertainty, as is the nature of such moments.
Outside of these events, and at these kinds of spread levels, Euro credit has historically offered diversification from other asset classes, lower durations, consistent income, and could potentially act as an additional buffer against a growth shock.
All data sourced from Bloomberg as at 30 May 2022, unless otherwise stated.
Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass. The above information does not constitute a recommendation to buy or sell any security. Past performance is not a guide to the future.