Case for Investment Grade Bonds: Europe

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.

Fundamentals

Euro denominated IG bonds remain low risk, given the following:

• Tail risks have moderated materially, as the macro picture has improved. In particular, natural gas prices have fallen sharply due to a mild winter and a resolution to the energy storage crisis. Also, the reopening of China has had knock-on positive effects on the global economy.
• Earnings have proven resilient in 2022, with robust interest coverage, cash flows and margins results, driven largely by the Energy sector.
• Margins have also been firm despite material increases in input costs because companies were able to pass through costs to consumers, who had built up stashes of savings.
• On the other hand, the European labor market remains tight with unemployment still at a record low 6.5%. Core inflation (which excludes any offset from energy price declines) remains elevated, and it will likely be sticky given the labor regulatory landscape.
• Wages and prices continue to run hot, keeping the European Central Bank (ECB) in tightening mode. This is especially true since European spread products have continued to rally despite decidedly hawkish ECB rhetoric. The ECB raised rates 50bps in its February meeting, and said that it will “stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to its 2% medium-term target.”¹
• Moving forward though, tightening ECB policy, slowing growth and decelerating inflation could erode companies’ pricing power, putting pressure on margins.
• Gross and net leverage have ticked up, in recent quarters, but are still showing improvement versus 2021. Cash to debt remains high relative to pre-COVID levels.

Technicals

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.

Valuation

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).

The Role of IG Bonds

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.