27 APR


Fixed Income , Topics

Credit markets appear expensive

Corporate Bond Strategy

The good performance of sovereign rates was also felt in the corporate bond universe as convertibles, global high yield and the emerging market asset class saw positive returns in March. US Financials produced a stronger performance (and was in fact one of the top performers) than their European counterparts (which were still positive). On a sector level, in terms of Euro credit, all sectors delivered a positive performance, with Telecoms and Consumers outperforming Financials and Insurance in a reversal of the previous month. Within the capital structure of financial credit, once again the riskier tranches delivered a strong performance, with Subordinated Debt and AT1 (Contingent Convertibles), along with Corporate Hybrids, leading the way, though all tranches delivered a positive performance.

Credit markets appear expensive

We are entering the period of the publication of company results, which we expect to be quite strong, and fundamentals should be positive, thanks to a supportive business cycle. Leverage is shrinking, the business cycle will restore EBITDA margins and interest expense charge coverage is better thanks to the lower financing rate. On the technical front, supply has been quite strong, especially on Euro investment grade. The momentum on global credit, which has been very positive over the past year, is now starting to weaken. With credit spreads tightening considerably on risky assets, key segments are running out of juice in the corporate bond universe and appear to be increasingly expensive. On the Euro high yield asset class, for example, the current risk premium is 340bp, well below the target spread of 380. The asset class, however, continues to generate inflows, primarily as a result of the lack of alternatives. In the US, the default rate continued to decelerate to 4.4% end-February and valuations, after the strong spread-tightening, are already integrating the better corporate fundamentals. In terms of alternatives, there could be a rotation from fixed to floater products but a large number of investors face restrictions. Another alternative could be to switch towards more products that present higher yields, like Emerging debt.

Favour European financial credit, profit-taking on subordinated debt

We continue to overweight the financial sector vs. the non-financial sector, as the former benefits from better fundamentals and attractive valuations. The end of additional QE and talks of a probable tapering could have an effect on the risk premiums of non-financial corporate bonds, leading to a widening of spreads. However, the financial sector is supported by improving capital reserves (and asset quality), better margins on the back of rising interest rates, as well as the regulatory landscape. Non-performing loans are also falling (even in Italian banks). Since the beginning of the year, supply has been very strong (EUR 65 billion) and much higher than on the non-financial sector (EUR 45 billion).

It is important to note that the expected returns for the year have already been achieved. Furthermore, subordinated debt has markedly outperformed the Senior debt segment over the past 6 months and spreads are now at 2-year lows. In this context, we are taking some profits on European financial subordinated debt.

Cocos still the instrument of choice

Within the financial sector, CoCos continue to be our instrument of preference. The asset class is benefiting from earnings recovery, lower duration and a weaker correlation to US Treasuries. The sub-set continues to perform well, supported by the strong carry and the positive news from both the Italian and German banking sectors. In terms of yield, these instruments are matching the levels presented by US high-yield credit (though there has been some small widening on US HY, which we will monitor). Technicals are also sound as there is a strong appetite from investors (primarily asset managers, insurance companies and pension funds), though we note that supply appears to be reducing. We remain selective as the asset class could witness volatility (as a result of specific events such as any announcement of new regulations) and litigation riskson several banks. The extension risk does not seem to have been priced in, as the yield-to-maturity is the same as the yield-to-call.

Regarding the Lower Tier 2 (LT2) segment of the capital structure, we note that short-dated papers have been the bonds that have tightened the most, as the perception of extension risk has improved with the tightening of the market and the emergence of the senior non-preferred Tier 3 market. We notice that there is less pressure on the supply as a result of the new Tier 3 tranche that came into existence in 2017 to fulfil regulatory requirements. The LT2 tranche also presents attractive risk premiums compared to the rest of the corporate bond sectors.