Screen the Euro fixed income market in the era of three ‘lows’

Letter to investors

As 2020 approaches, the uncertainty in the market has receded but there are still risks ahead involving macroeconomic, political and technical factors. Under such a scenario and with central banks being accommodative, we do not envisage a major increase in European core bond yields from their current levels given the limited growth potential and the scarcity of tools left in the ECB’s toolkit to stimulate the economy. Should the economic situation deteriorate, there could be room for yields to fall, but probably not to the lows reached in late August/early September.

Next year the ECB will play a crucial role in market liquidity and the financial sector, with its new two-tier banking reserve system and TLTROs boding well for subordinated financial bonds, which are a favoured instrument in the hunt for yield. The central bank will also support credit markets with its recently relaunched purchasing programme. Evidence from the first few weeks of QE2 suggests that the ECB will increase the proportion of corporate bonds in its overall asset purchases, supporting the corporate bond market.

Regarding our key investment convictions for 2020, we believe that alpha will be generated mainly using tactical strategies on duration and curve trends until clearer signals on the market direction allow investors to embrace a more strategic view. Government bond yields are likely to remain stagnant. In a low-growth scenario, investors seeking flattening positions should chase any available premium. Additionally, government bonds from countries that trade at large spreads versus core countries will remain attractive. Inflation-linked bonds are cheap and could be worth pursuing, should headline inflation move higher.

The prolonged monetary policy easing of the main central banks will support the entire credit spectrum and investors will likely favour the European segment in their search for yield rather than other geographies, due to its better fundamentals and valuations. In the Euro investment grade space, we prefer bonds that benefit from positive carry. We are positive on the Euro high yield segment, with a focus on cyclical names should trade tensions ease. In the financial space,we favour CoCoand lower Tier II bonds. We are mindful that greater scrutiny is needed on liquidity for the higher yielding sectors in 2020.

In any investor’s portfolio, Euro fixed income offers diversification and stability under our central 2020 scenario. Investors could play the “core” component of their Euro fixed income portfolio with a focus on aggregate strategies that can play duration flexibly, together with yield curves and cross region/sector allocation. Investors could also play a satellite allocation to enhance income through high yield and subordinated bonds, as well as a continuum of listed and public debt.

Investment-grade credit is well bid, thanks to strong ECB support

In a low-yielding environment, investors have favoured the limited positive-yielding segments of the Eurozone bond market. They have invested in bonds yielding appealing spreads over government bonds, e.g., bonds with high betas or longer-dated bonds (with maturities above 10 years) at the expense of shorter-dated securities.

In the Euro IG space, we favour bonds that benefit from positive carry, currently at around 50 bps for the Euro Corporate Index. At the sector level, investors should favour CoCo and lower Tier II bonds in the financials space, with a preference for sectors such as telecom, energy, real estate and utilities. Selectivity will be a top priority for investors in 2020, as dispersion is high and picking the right names will be crucial.

The main driver for the credit market will be the new ECB corporate sector purchase programme (CSPP). The ECB’s QE2 programme has started on a strong footing and with a tilt towards the private sector. In the first three weeks of November the ECB bought €20.2bn of bonds, higher than the announced monthly pace of €20bn.

The private sector has accounted for 38% of the ECB’s purchases thus far, a higher share than in the first programme. Currently at 23%, corporate bond purchases have picked up, as their share of the overall APP previously ranged between 10% and 20%. We believe this trend will continue and the share of corporate bonds on overall asset purchases will be higher than in the first QE round due to multiple factors.

Firstly, the ECB’s current holdings of corporate bonds account for only 20% of the eligible universe compared with 39% of supranational bonds and 25% of sovereign bonds. In addition, the eligible universe has expanded in 2019 from about €840bn to €910bn currently, thanks to strong new issuance.

The space available on private programmes will allow the ECB to concentrate its purchases on these market segments and alleviate the scarcity issue of a few sovereign bond markets (we estimate the ECB’s holdings of German debt as being close to 30%). A tilt towards the private sector will allow the QE2 programme to run for longer, with no amendments needed to the issue/issuer limits on the public sector purchase programme (PSPP). Finally, corporate bonds currently account for only 7% of overall ECB holdings, so there is room to increase such holdings while keeping credit risk under control.

All of the above observations bode well for corporate bonds’ technical factors and this market should stay well supported into next year. However, we should bear in mind that it is still early days in the new QE2 programme and that some frontloading in purchases usually occurs before the holiday season. Therefore, evidence from the first few weeks of purchases may not match with the overall investments of the programme.

APP reinvestmentswill also support market trends in 2020. Forthcoming redemptions within the PSPP announced by the ECB point to an estimated increase of around €40bn in 2020 compared with 2019. In relation to the CSPP reinvestments, we estimate that these will rise significantly, from an average €400m per month in 2019 to an average of €1.2bn in 2020. CSPP reinvestments will total an estimated €16-18bn in 2020 as a whole, compared with just €6bn in 2019 and €4bn in 2018.

How to play Euro fixed income opportunities

In the ocean of uncertainties described above, Euro fixed income represents an island of relative stability. Factors to focus on include growth levels that are neither too hot nor too weak, credit fundamentals that are not overextended (with relatively low funding costs) and technicals that should bring some price stability to the market (the ECB’s CSPP and two-tier reserve remuneration scheme), as well as the attractiveness of the asset class for overseas investors, notably Asian investors. Combining these elements, Euro fixed income offers both diversification and stability in what is likely to be a more volatile environment.

Investors should focus on building a core bond allocation with a robust process to select the best high-quality and liquid assets. In addition numerous market technicals (many of them generated by ECB’s policy) offer room to supplement the core allocation with a set of relative-value strategies. As to optimise income generation investors might complete their allocation with a selection of assets providing higher expected returns, such as high-yield bonds, subordinated bonds or continuum portfolios with a mix of bonds, loans and securitised assets.

In the hunt for yield, a favourite for next year is the financial subordinated bond market. Subordinated financial bonds show better valuations compared to both senior financial bonds and non-financial bonds, the latter being eligible for the ECB’s CSPP. The European banking sector has progressed noticeably in terms of capitalisation and reduction in non-performing loans. In 2020 it will benefit from recent ECB measures including TLTROs and the two-tier reserve remuneration scheme. As such, the subordinated bond market offers yield opportunities. An in-depth credit research would help to add value by detecting idiosyncratic risks in this space. ESG factors are also increasingly relevant in the selection process and they should become mainstream in fixed income investing.

A key focus for investors in 2020 will be market liquidity. This is crucial in facilitating normal operations and asset price movements in financial markets, as highlighted in our recent piece Liquidity dilemma needs a regulatory response. Assessing liquidity conditions is an intrinsic part of building and managing fixed income portfolios and should be an inherent part of the investment philosophy of any fixed income investor. To assess liquidity conditions, it is vital to regularly monitor trading data. More specifically, fixed income investors should consider the client’s liquidity requirements. Therefore, asset managers should adapt their investment style to suit the client’s liquidity needs, whether via an active, model-driven or ‘buy-and-hold’ type approach. A continuum of investment solutions with different income/ liquidity profiles can help investors choosing the best fit for their investment needs and liquidity requirements.