Revisiting fixed income opportunities after the European institution appointments

IMPLICATIONS FOR THE EUROZONE AND THE ECB

What is your view on the future direction of the European Commission on the relevant matters for the EU? What will the main differences be from the previous Commission and what are the main challenges?

In a particularly uncertain international environment and with economic divergences between Member States still very pronounced, the Commission’s role will inevitably become more political. For instance, trade negotiations with the rest of the world will take centre stage. The challenges are well identified. But Europeans must move fast. It is indeed likely that the EZ (or the EU) will face a recession in the coming years, which will require a consolidation of the economic and financial architecture of the EZ to increase its resilience to shocks.
Indeed, more than 10 years after the great financial crisis, the Monetary Union is still split between surplus countries and countries in deficit. This polarisation weakens public investment and reduces potential growth. The EZ must transform its growth regime and reform its financial architecture. This is the only way to address the economic and environmental challenges in the medium to long run.
There is a unique window of opportunity with the 2021-2027 Multiannual financial framework currently being negotiated, as it will set a path for EZ development for the coming decade on key issues (agricultural and cohesion policies, digital economy, migration, climate objectives, etc.).

On the ECB, the consensus is for continuity of Draghi’s approach with Lagarde. Do you agree?

The IMF in general and Christine Lagarde in particular have always supported the ECB’s policy, whether it be QE programmes, TLTRO¹s or negative interest rates.
Moreover, Lagarde has often said, as has Mario Draghi, that monetary policy was not the “only game in town”, and that low rates should be used to mobilise fiscal policy, where there is fiscal space. Lagarde is thus expected to act in continuity, which should enable Draghi to implement expansionist measures before she arrives at the ECB without expecting them to be called into question later. The roles and responsibilities of central banks and governments are, in theory, quite distinct.
But with quantitative easing programmes, the boundary between monetary and fiscal policy has been blurred. As a result, during the next financial crisis, the ECB and governments will have to work in close cooperation. Lagarde is very used to talking to heads of states – a skill she developed at the IMF – and this is something that will be useful to her in a monetary zone made up of still very disparate economies. We can already see that Lagarde enjoys the confidence of investors.

FIXED INCOME INVESTMENT IMPLICATIONS

Given the new appointments, do you see a continuation of falling yields, to what extent and should investors play it?

Markets are discounting a very dovish central bank policy, supported by the most recent official communication as well as economic data. At today’s yield levels, market participants are now quite sensitive to any better economic announcement, as per sampling of the latest US job report (+224K) or French industrial production (+4% yoy in May). The current economic cycle is mature and relies more and more on internal demand, thus implying we should not expect a sharp acceleration of growth. Inflation remains low and for the ECB, as well as for the Fed, the risk is quite asymmetric. Our main scenario highlights central banks remaining supportive and quite dovish. As a result, we may see a pause in the declining trend of rates. We do not predict a significant increase of yields; we rather anticipate continuity in the hunt for premium by investors.

Where is the oasis of yield in fixed income? What are, in your view, the strategies to deliver returns to investors in the current phase and what are the main risks?

Traditionally, to increase their yield, investors have ended up taking additional liquidity risk (private debt, structured credit), duration risk (classic way to extend exposure at the far end of the curve with sovereign long-dated bonds) or default risk (high-yield). Within the defined low rates scenario unfolding on both sides of the Atlantic, the sub-segment becomes a key area to look at if properly screened. More specifically, the subordinated³ corporate segment is an alternative high yielding solution. These securities provide historical premiums over senior debt. The vast majority of subordinated bonds are issued by quality investment grade (IG) names (much reduced default risk), trade to call-date (short-dated, with low duration risk) and are composed of large issuances (with enhanced liquidity). Finally, valuations remain supportive of the subordinated debt sub-segment. Selection is key in this potential space; the ability to research across this complex universe and long-term experience in dealing with these instruments across different market environments are vital to avoid taking unwanted risks. We reiterate that fixed income markets continue to offer a number of opportunities, notably in the long end of sovereign curves, with flattening trades and credit not being at the historical lows, etc. In addition, should central banks become more involved, we will see less spread dispersion in the IG universe, which represents a strong call for the credit value factor.

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1. TLTRO: The targeted longer-term refinancing operations (TLTROs) are Euro system operations that provide financing to credit institutions for a predefined period of time.

2. Curve flattening: A flattening yield curve may be a result of long-term interest rates falling more than short-term interest rates or short-term rates increasing more than long-term rates.

3. Senior and subordinated debt.  Subordinated debt is any type of loan that's paid after all other corporate debts and loans are repaid (senior debt), in the case of borrower default. The senior debt takes priority, it is more secure than any other debt.