Euro Investment Grade Credit – Caught in a Yield Downdraft
European investment grade (IG) credit has made a convincing recovery after its September wobble. A rebound in equities, despite uncertainty over the resurgence of the pandemic, has encouraged market participants to re-enter risk positions. A step up in corporate bond purchases by the ECB, while primary issuance has started to fade into the end of the year, has also helped the dynamic. Indeed, the option-adjusted spread on the Bloomberg Barclays Euro Aggregate: Corporates Index has tightened to around 110bp, its tightest since 27 February 2020.
Further spread narrowing remains possible but is likely to be slower. The decline in the Bund yield, deep into negative territory, has created a strong downdraft for spread assets, dragging their yields lower. As Figure 1 illustrates, IG corporate yields may have fallen, but other risk assets, in this case 5Y Italian BTP yields, have declined even faster. Over the past 10 years it has been unusual for the 5Y BTP to trade with a yield below that of Euro IG credit. The only sustained period was in 2015-16 while the ECB bought government debt but not corporate bonds – CSPP (Corporate Sector Purchase Programme) purchases of credit started in June 2016.
There may also be specific reasons for the strong performance of peripheral bonds in 2020 with the EU’s Recovery and Resilience Facility, its centrally funded plan to recover from the pandemic, seen compressing intra-Euro spread risk. However, the bigger picture is that, as yields head down into negative territory, assets offering yield pick-up are going to be an increasingly important source of returns.
Figure 1: All risk asset yields have been dragged lower by negative rate policy