A good resistance of credit in spite of the rates' increase

Eurozone credit markets saw an unexpected rise in German yields in late April. The scale and speed of the increase surprised many: a 50 bp jump in just a few trading sessions after a virtually uninterrupted decline that had continued over several quarters. The correction may be due to a combination of factors: profit-taking, a rebound in the price of oil, an improving economic outlook in the eurozone and an increase in inflation expectations. How did the credit markets react? What is the best positioning for an investor to adopt?

The upward move by the German Bund erased some of the overall gains on IG bonds.

Tensions over government bonds have weighed down the overall yield of IG bonds in the past few weeks. They erased some of the positive performance delivered since the beginning of the year: this yield plunged from 1.8% in mid-April to 0.43% by late May. Volatility was particularly high on the 7-10-year maturities and higher still for high-quality issues (AAA-AA) given their longer duration.

The good resiliency of HY should be highlighted: cumulative total yield since the beginning of the year was barely impacted by the Bund's correction. By the end of May it was 3.7%. This outstanding performance is due to the shorter duration and the wider spread of this segment. The negative contribution of the “rate effect” was offset by the positive “spread effect”.

But as far as spreads are concerned, performance is still robust.

The Bund's correction led to a tightening of credit spreads. The IG and HY bond indices narrowed 4 bp and 6 bp, respectively, between mid-April and mid-May. How do we explain such good performance from the credit markets?

As a general rule, a sharp, rapid rise in the yields of the highest-rated countries has the opposite effect on spreads. Spreads narrow as the economic outlook improves. The latest published data on eurozone growth seem to confirm the positive signals sent by macroeconomic indicators. The positive earnings reported by European businesses for Q1 confirmed the impact of the euro's depreciation relative to previous quarters (See the Weekly Letter May 11-15).

Technical factors also played a positive role during this bout of high bond volatility.

• Activity on the primary market slowed dramatically during this bout of high bond volatility. As a reminder, the first quarter was marked by record activity in the IG segment (€130 billion in Q1 2015 vs. €108 billion in Q1 2014). This increase in activity is linked to the arrival of non-European issuers, particularly Americans, attracted by the exceptionally low interest rates (€50 billion in Q1 2015 vs €27 billion in Q1 2014).

• Meanwhile, an analysis of the data published by EPFR attests to continued weekly flows into eurozone credit. IG credit registered positive inflows during the last weeks. The HY market also registered some inflow but in far smaller proportions.

The ECB's QE programme is just getting started

We do not regard this bond sell-off as the manifestation of a new trend but more of a correction of past excesses. 20% of the bond market was reporting negative yields before the Bund correction compared to 13% after. The ECB's QE programme is expected to uphold a favourable technical configuration over the next few months and quarters. Benoît Coeuré announced that the ECB would be temporarily frontloading its purchase activity in May and June to maintain a monthly average of €60 billion during the summer holiday period. Although he regards the recent correction as normal, he is worried about the rapidity of the reversal, which is a sign of reduced liquidity in the bond market. Remember that 85% of the QE programme has yet to be completed! We remain upbeat about credit and maintain a preference for high beta segments (HY, BBB and financials).

The divergences in the monetary policies of the ECB and the Fed, which appear to be accelerating, give us reason to show a preference for eurozone credit over dollar credit. The ECB's QE programme is expected to uphold a favourable technical configuration over the next few quarters. Any increase in the Fed funds rate not priced in by the market may have a negative impact on US risky assets (particularly equities and HY credit), which have had a major boost in recent years thanks to extremely accommodative monetary policies. Should dollar credit deliver poor performance following an increase in key interest rates, it would be a good buying opportunity as the valuations offered by US credit are more attractive than those of the eurozone. However, so far our preference remains for eurozone credit. The main risk under our scenario remains a political/economic event such as a Greek exit from the eurozone.