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What are the best opportunities still available on the European IG market?

The essential

Economic outlooks are improving but remain fragile. Today, investors’ scenarios expect a tightening of US monetary policy and the end of the low interest rate climate that has prevailed on bond markets worldwide. 

In such an environment, what is the way to position oneself on the euro Investment Grade (IG) bond market? The spread on peripheral debt is nearly double that of core debt for financial and non-financial issuers. The yield on medium/long-term maturities is particularly attractive. Financial debt is still more attractive than industrial debt on different maturities. We remain very cautious on the core non-financial issuers segment. The spread is too low and no longer compensates for macro risk or the risk of an interest rate hike. The most positive stages of the cycle are behind us (in terms of tightening spreads and higher yields compared to governments bonds). The most likely scenario over the coming months is a gradual normalisation of spreads. As a result, to maximise performance, positioning on segments that offer the best spread is an attractive proposition.

 

Economic outlooks are improving but still remain fragile. Today, investors’ scenarios expect US monetary policy to tighten and the yield on US Treasuries to rise. In contrast, the ECB reiterated that its monetary policy “will remain expansive for as long as needed” and that it will continue to provide liquidity to meet banking needs. Against this backdrop, investors are becoming increasingly cautious now that they are faced with the risk of rising interest rates. In such an environment, what is the way to position oneself on the euro market for private Investment Grade (IG) bonds? What is the best hedge against increased interest rates? What are the best opportunities still available on this market?

The European IG market has a more defensive profile than it had before 2008

With €1.5 trillion in debt and 1,700 issues, the size of the market has changed little since 2010. An analysis of its composition reveals some interesting information. The profile of companies in the European IG market is now more defensive that it was before the 2008 crisis.

  • The European IG market is divided fairly evenly between financial and non-financial issuers. The financial sector accounted for most of the market before the Lehman Brothers crisis. But the supply of financial issuers contracted following bank deleveraging, the ECB’s extraordinary measures (LTROs) and regulatory changes.
  • The weighting of BBB issuers doubled within five years and now represents over 40% of the index. This trend is explained by ratings downgrades due to the sovereign debt crisis.
  • The IG market has limited exposure to peripheral countries: Italy (9% of debt), Spain (5%). It is concentrated mostly in France (22%), Germany (16%) and the Netherlands (8%). 

Within the non-financial IG market, the weighting of defensive sectors increased in recent years, eventually representing the majority: 73% of debt at the end of 2012 vs. 70% at the end of 2007. Most defensive securities are in the Utilities and Telecoms sectors. We also note that the breakdown between cyclical and defensive sectors is different for eurozone core and peripheral countries.

  • Of core-country issuers, 32% are in cyclical sectors such as automotive, basic industries, capital goods and consumer staples.
  • Almost all peripheral issuers are in defensive sectors.

Within the financial IG market, senior debt—the most defensive and lowest beta—now represents the largest segment, supplanting subordinated bonds. The proportion of subordinated debt declined significantly: downgrading to high yield, buybacks, etc.

Technical factors continue to sustain credit

The IG market is sustained by the low supply of new issues. Banks have issued little since 2010 and the non-financial sector has not compensated for this lack of new issues.

  • The supply of financial issuers remains low. The net volume issued is negative: since the beginning of the year, it has reached -€158bn (net volume issued is the volume of new issues subtracted from the volume of maturing debt).
  • The shrinking of banks’ balance sheets has forced businesses to rely more on market financing. But businesses remain generally cautious in terms of their investments. Therefore, the supply of industrial issuers’ bonds is not enough to offset the decline in the supply from financial issuers. The net volume of new issues has reached +€23bn since the beginning of the year. In September 2013, the primary market posted record volumes on this segment since the end of the summer break.

Demand for IG issuers remained solid. IG funds were relatively spared by outflows beginning in May. The announcement of a gradual slowdown in the Fed’s quantitative easing programme triggered a general correction on risky assets, including spread products. We saw more of a shift within the European IG segment: investors repositioned on shorter maturities to hedge against the risk of increased interest rates (source: EPFR). Given weak growth outlooks, the risk of accelerated outflows to the equity market remains limited. We note that the demand for new issues remains strong. Subscription rates are still high.. 

Eurozone companies’ fundamentals remain solid

Since 2008, businesses have been very cautious in managing both their operations and their assets and liabilities. Second-quarter results generally exceeded expectations.

  • Revenue growth remains very low, especially in the eurozone. Margins declined slightly: costs remain under control.
  • Investment policies varied. Excessively indebted businesses are still cautious. In contrast, businesses with healthy debt ratios are beginning to increase their spending on investments (capex and/or acquisitions).
  • Net-debt-to-EBITDA ratios are slightly up. Companies’ cash levels remain satisfactory. 

Cyclical businesses underscore that the economic climate remains uncertain and that a significant slowdown in emerging markets could impact their profits. IG companies in the eurozone’s periphery are still too heavily indebted and will remain “creditor-friendly” in the medium term. The eurozone is still hindered by fragmentation between the eurozone core and periphery. Obtaining access to credit is more difficult and more expensive for peripheral businesses.

What kinds of performances are we seeing on credit markets?

Since the beginning of the year, the high-beta segments of the credit market have performed well. The determining factors were monetary policies (the Fed’s maintenance of the status quo in particular) and the improved global macroeconomic outlook (an encouraging sign for microeconomic outlooks). Therefore:

  • HY narrowed to 75bp whereas IG remained virtually stable at 140bp (adjusted spread option). Within IG, the high-beta segments outperformed: peripheral financial and non-financial issuers declined by 81bp and 7bp, respectively, whereas non-financial core issuers increased by 12bp.
  • HY credit posted a +6.5% yield vs. only +1.4% for IG credit. Within IG, financial and non‑financial peripheral issuers posted better performances than non-financial core issuers (+5.2% and +2.9% respectively vs. +0.6%). 

Positioning on issuers that offer an attractive spread

We have identified two significant risks inherent to the European IG market:

  • Macro risk. A worse-than-expected deterioration (return of sovereign risk in the eurozone) or better-than-expected growth (accelerated increase in interest rates and rotation to equity markets) would have a negative impact on credit.
  • The end of the low interest rate climate that has prevailed on bond markets worldwide.

Let’s focus on the second risk: what strategy should be adopted in a context of interest-rate increases? A bond’s yield includes an interest rate component and a credit component. A very bleak scenario for credit would be an increase in interest rates coupled with widening spreads (scenarios seen in June 2013). However, historical data shows that when bond yields increase, credit spreads decrease: an improved economic climate leads to better microeconomic outlooks. Ever cautious, central banks will do anything to avoid an increase in long rates that hurts growth. In this context, the spread offers protection against an increase in interest rates. It is therefore best to combine issues with high potential spread tightening and short to medium term maturity. The possibility that IG spreads will tighten is fairly low (see September 2013 Cross Asset article “The link between credit spreads and bond yields: is this time different?”). However, this market offers attractive sources of value:

  • Peripheral debt. The spread on peripheral debt is nearly double that of core debt for financial and non-financial issuers. The yield on medium/long-term maturities is particularly attractive.
  • Financial debt. The ratio of financial-to-non-financial debt spreads for companies in the core and periphery reached 1.35x and 1.5x respectively. It is still more attractive than industrial debt on different maturities. At the same time, in order to offset sovereign risk with the financial structure, we continue to favour core issuers in the Lower Tier 2 segment that provide the highest beta and peripheral issuers in the senior debt segment with low betas. 

In contrast, we remain very cautious on the core non-financial issuers segment. The spread is too low and no longer compensates for macro risk or the risk of an interest rate hike.

The most positive stages of the cycle are behind us (in terms of tightening spreads and higher yields compared to governments bonds). The most likely scenario over the coming months is a gradual normalisation of spreads. As a result, to maximise performance, positioning on segments that offer the best spread is an attractive proposition.

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Almost all peripheral issuers are in defensive sectors

 

 

 

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Some companies are beginning to increase their spending on investments

 

 

 

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The spread on core non-financial issuers is too narrow

 

 

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Valentine AINOUZ, Strategy and Economic Research at Amundi
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