The second part of 2015 was characterised by renewed volatility. Spreads widened significantly in August, September and more recently in December, mainly on the back of increasing concerns tied to the consequences of the slowdown in China and the fall in oil prices. EUR IG and EUR HY bonds respectively started 2015 offering 97bp and 409bp spreads. As we are writing, they are now both higher by 42bp and 164bp, respectively trading above 139bp and 573bp. Indices have reached a YTD high and have even returned to the levels seen in 2013. We continue to expect a gradual recovery in developed economies sustained by domestic demand, in spite of recent concerns over global weakness. In this context, how should we be positioned against this euro and dollar credit market backdrop?
The technical picture should remain well oriented for HY and, to a lesser extent, BBB issuers
The euro credit market should be supported in 2016 by the ECB’s commitment to retain an easy monetary stance. The ECB announced a range of measures to tackle too-low inflation, from a cut in the deposit rate floor to an extension of its bond buying programme until March 2017. These new measures were quite disappointing in light of market expectations. In any case, we need to keep in mind that the ECB’s policy is very accommodating and will remain so for years. ECB policy measures have contributed significantly to pushing sovereign and corporate bond yields down over recent years. The impact on the euro credit markets is mixed.
On the positive side, appetite for credit should persist in the face of low sovereign rates. Technicals should continue to be supported by the search for yield. 20% of the entire eurozone fixed income market is offering negative yields, and a remarkable 30% of debt is close to zero. The yield dynamics should be more favourable to high yield and, to a lesser extent, BBB issuers.
On the negative side, low absolute yield could become somewhat of an issue for Investment Grade credit:
Our main concern at this stage is the contagion from US credit outflows to euro credit, especially in the HY segment. High yield and, to a lesser extent, Investment Grade credit recorded very large outflows over the last weeks of the year, mainly because of contagion from US HY. However, we have to keep in mind that the fundamental picture is completely different. US HY has substantial exposure to the energy sector and the leverage for US companies is now at its highest point over the past decade.
Corporate fundamentals remain in line with bondholders’ interests in the eurozone
Divergences in economic momentum are visible in companies’ balance sheets. US companies are once again leveraging up, in contrast to European companies, which remain in cash-flow preservation mode. Earnings pressure has kept European corporates cautious and debt growth remains muted. Euro Investment Grade and High Yield issuers remain at that stage, stuck at the beginning of the leveraging cycle.
Bottom-up factors make EUR HY bonds more resilient than the US HY universe to violent shifts in energy prices. Two elements play quite a role: the exposure to energy/commodity sectors and the weight of low quality issuers. We expect the European high yield default rate to remain below 2% in 2016. The situation is different in the US. The strong link between oil price levels and the US HY energy sector will inexorably drive default rates higher in the next one to two years. In recent months, we have already seen an increased volume of credit events concentrated in the energy and commodity sectors and more are likely to occur over the coming quarters.
Are spreads attractive?
Indices have reached a YTD high and have even returned to the levels seen in 2013. Given the current macro environment:
Spread looks quite attractive versus improving PMI levels. We continue to expect a gradual recovery in developed economies sustained by domestic demand, in spite of recent concerns over global weakness. The fall in oil and commodity prices is supportive for most of the non-energy sectors.
Spread also looks quite attractive versus peripheral sovereign bonds. Government bonds are directly supported by the ECB buying programme. The ECB’s QE has provided major support to sovereign rather than corporate bonds, especially in the short- to medium-term segment. To compare equally rated bonds: The average yield of a 5-7 year BBB-rated corporate bond is 2.0%. An equally-rated 5-year BTP is around 50bp. This amounts to a ratio of almost 4, compared to just 1.6 at the start of 2015.
BBB-BB rated issuers increasingly look like the most important supplier of yields. Before the last ECB announcement, 28% of the overall EUR fixed income market offered a negative yield. It was just 9% at the start of 2015. BBB and BB corporate bonds account for 55% of still available yield, while representing just 11% of outstanding debt.
To conclude, the sharp widening of the previous weeks has created some opportunities. The euro credit market should be supported in 2016 by positive fundamentals, and particularly by the ECB’s commitment to retain an easy monetary stance, ultimately supporting the ongoing search for yield. We are favouring issuers that offer spread in the IG universe and BB-rated issuers in the HY universe. At this stage, the major risk in our scenario remains the correlation with the US markets.
Spreads are back to the levels observed in 2013
The European high yield default rate will remain below 2% in 2016