Look for the signs

The following is an extract from our Q1 Active Insights publication.

Since the European corporate bond market was established in the early 2000s, there have been several evolutions of index composition at the sector level. Sector-specific growth stories, and subsequent crises, have led to large fluctuations in the composition of the index.

For example, investors saw a large amount of debt from telecommunications companies after the 3G licence spending spree in the early 2000s. They also saw the rapid growth of the banking sector ahead of the global financial crisis (GFC). From 2019 to 2021, there was an explosion of real estate issuance, which we flagged as a potential concern in a blog some time ago. The sector has come under pressure in the higher interest-rate environment of the last two years. Currently, bank bond issuance is on the rise, while long-term debt in the healthcare sector has also risen.

The ECB – a dominant force in European corporate credit

When looking at the European corporate credit market, investors are unable to ignore the close links with European Central Bank (ECB) policies. Since 2016, the ECB has been a dominant force in the market, purchasing hundreds of billions of euros worth of bonds under the Corporate Sector Purchase Programme (CSPP), as part of its quantitative easing policy.

Despite one of the quickest rate-hiking cycles in history, whereby the central bank raised the benchmark interest rate by 4% within 18 months, taking the key refinancing rate to 4.5%, risk assets have held up remarkably well. Since the start of 2023, the spread of European investment-grade bonds over German government debt has tightened by around 30 basis points (bps)[1]. This is despite European growth looking challenging, with economic indicators suggesting the possibility of a recession and the ECB not expected to offer further support.

We believe the attractiveness of overall yields at levels over 4%, or even 4.5%, partly explains the strong demand for euro credit in 2023; at least until the end of the year, when the rally in rates pushed all-in yields below the 4% level[2]. When we look at spreads in a historic context, they still look attractive, in our view. That said, when set against our more negative economic outlook, we remain cautious.

We believe a fair amount of positive news on the inflation side appears to be discounted, with markets currently pricing in a drop of over 1% in ECB policy rates before the end of the third quarter of 2024. In addition, there is the question as to what extent the lack of buying by the ECB will continue to be counterbalanced by inflows into the asset class.

Implications for investors

As a result, we remain defensively positioned, with a substantial underweight position in lower-rated issuers, and with a preference for less cyclical, more defensive companies. Banks continue to offer good relative value, in our view, while the inherent cyclicality is somewhat countered by stronger balance sheets. However, the mini banking crisis in March 2023 illustrated, once again, that the performances of issuers in the sector are highly correlated, and we continue to limit our overall exposure for that reason. Furthermore, the banking sector continues to grow as net supply continues to be above the index weight.

Identifying longer-term investment themes, sector deep-dives and bottom-up selection will continue to be core elements of our investment process over the next 12 months. We said 2023 would be challenging. We expect 2024 to be no less so, and we continue to prepare ourselves for any form of landing – soft or otherwise.

The above is an extract from our Q1 Active Insights publication.

[1] Source: Bloomberg as at 31 December 2023

[2] Source: Bloomberg as at 31 December 2023