In European investment grade (IG), fundamental risks remain modest, but the sector now trades with quite attractive yields. Income levels have risen to levels that can provide low-risk carry, should valuations stay rangebound, or provide a cushion for returns if sovereign rates back up or if spreads were to widen.
While inflation remains high, it is starting to soften (see Bonds Are Poised for a Turn). As it falls, spreads could also benefit from the greater visibility into the level of terminal rates and the end of this challenging phase of the credit cycle.
Euro denominated IG bonds remain low risk, given the following:
While Euro IG supply was weak in the 1H2022, it bounced back in the second half, and then soared to a near-record-breaking EUR108.5 billion in January 2023 (mostly Bank issuance).2 However, this booming supply was met with massive demand from retail investors, who poured $15 billion into euro IG in 2H22. The sector also continues to see strong interest from institutional investors who can now meet their hurdle investment targets with euro IG.
Moving forward, demand will likely remain strong, while companies will likely be conservative in issuing new debt given the rising cost of funding.
For European sovereigns, the supply-demand balance could become less favourable because of QT and the resulting elimination of the ECB as buyer. Japanese demand could also soften because the BoJ recently announced no change to its Yield Control Curve (YCC),3 which could ratchet up Japanese rates and lead to lower demand for Euro corporates. Still, we expect the supply and demand dynamics to benefit the sector overall.
Euro IG was not immune to the fixed income rout of 2022; the sector lost 18.93%, which is its worst performance on record.4 However, as is well known, the loss was mainly due to an increase in sovereign yields, as the excess return for credit was only -1.02%. Euro IG started 2022 at a YTW of 0.46% , a paltry level of carry that offered little to no cushion against sovereign rates rising. Spreads widened 30bps due to a wide range of headwinds facing the sector, including the Russia-Ukraine war and the UK LDI crisis in the autumn.
However, a consequence of this poor performance is that euro IG yields have now reached their highest levels in over a decade—levels not seen since the financial crisis.5 Despite the rally in corporate spreads in 4Q22, rates remain attractive—even with inflation uncertainties and upward pressure on rates from global central banks. Embedded yields in Euro IG can help provide a cushion against further rises in bond yields and coupon income is set to rise in 2023 for the first time since 2010 – increasing by 21% y/y, to 42 billion euros. Coupons are set to rise due to higher funding costs, following the persistent decline in coupon income post GFC.
In addition, on a relative basis a higher premium currently persists for European IG versus US IG, following the underperformance of Euro IG throughout 2022 (Figure 1).
Global fixed income investors have spent years combatting zero or negative yields, only to now see cash or high-quality bonds offering positive interest rates. Investors can now generate positive returns from liquid, public IG portfolios, that can be used as dry powder for opportunistic investments that may arise, as rates continue to normalize and the macro picture improves.
IG can also continue to be a buffer against potentially volatility given the now likely return of the negative correlation relationship between stocks and bonds. IG could therefore offer downside protection against any potential drawdowns in equity markets. One option to consider here, is a Dynamic Asset Allocation process, in which investors choose a target level of volatility and dynamically shift their allocations to less-risky assets as market criteria changes (see: Downside Protection: Why it Matters for All Markets).
So, while company fundamentals are strong, the shifting macro environment could present future challenges. However, healthy balance sheets and light funding requirements in the near-term underpin the case that risks are low and the risk-return balance is appealing now for IG credit. The resilience of IG fundamentals make it worthwhile to consider taking advantage of attractive yields, spreads and carry now available in the sector.
1 European Central Bank, as of February 2, 2023. Monetarypolicy decisions (europa.eu)
2 Dealogic, Barclays Research, as of March 1, 2023.
3 Kato, Issei. “BOJ Keeps Yield Control Policy Unchanged.” Reuters, January 17, 2023.
4 Bloomberg, 12-month total return, as of 12-30-2022, based on the Pan-European Aggregate Index.
5 Bloomberg, YTW, as of 3-16-2023. Based on the Pan-European Aggregate Index, US Yield to Worst.
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