European credit – no stopping the flow

The below is an extract from our Q2 Active Fixed Income outlook.

The past: what just happened?

The two components driving returns of European corporate bonds moved in opposite directions in the first quarter, as the rise in government bond yields was offset by tighter credit spreads. Following a strong fourth quarter in 2023, government bonds sold off on the back of strong economic data and upside inflation surprises, but risk assets reacted well as the soft-landing narrative remained intact.

Strong flows into euro investment grade (IG) have continued to drive spreads tighter. Indeed, the last six months have seen more inflows than any of the previous six calendar years (see chart below). We flagged the gap in demand and the fact that the ECB is no longer buying corporate bonds in a blog, but these historically strong inflows have thus far made up for the lack of central bank buying.

Supply has responded to the increase in demand, and corporate issuers now appear comfortable with the new level of interest rates after the aggressive hikes of 2022/23. Interestingly, new issuance has been especially high from non-financials, having dropped in recent years.

The present: quality rules

We believe the best risk/reward can be found in higher quality euro IG bonds as the recent compression has resulted in less attractive valuations in higher beta segments of the market. Subordinated bonds, for example, have performed well since October 2023, with spreads looking relatively tight compared to senior bonds (see chart below).

The higher beta segments of the market will also be more vulnerable in negative market scenarios. We’ve taken profits recently by selling higher beta bonds and rotating into higher quality issues. As spreads approach the lower percentiles of historic ranges, we tend to witness a lack of dispersion between sectors and ratings within euro IG. We have seen that compression recently, but the post-pandemic era, and higher rates, have also resulted in more issuers coming under pressure, such as those in the real estate sector and some consumer-related names linked to struggling brands.

What could go wrong?

Credit markets more broadly have, so far, been buoyed by the strong economic data, but they could suffer if bond yields increase much more, or central bank cuts are not delivered.

Under that scenario, the higher interest rate environment could continue to put pressure on weaker capital structures. Coupled with any major disruptions (further geopolitical risks and significant changes regarding AI) we believe this could present challenges for certain companies.

Politics will remain a key focus in the coming months, with several major economies coming to the polls. There could be important implications for fiscal policy, inflation and bond yields.

Outlook

Sector and issuer specific challenges have thus far been relatively well contained, but there is a risk certain pressures could evolve into systemic problems. This is not our base case, and we believe that euro IG offers an attractive risk/reward ratio and some relative cheapness versus other parts of the credit market.

We urge caution on weaker names in the investment universe and put significant focus on bottom-up credit analysis and issuer selection. We expect to see strong interest from investors, which will continue to support the asset class, but we believe active credit management is necessary to avoid credit events in this new regime for rates.

The above is an extract from our Q2 Active Fixed Income outlook.