The solid performance of “Risk-on” assets was also felt in the corporate bond universe as convertibles, global high yield and the emerging market asset class saw positive returns in January. The US high yield market outperformed (and was in fact one of the top performers) its European counterpart as EUR-denominated assets generally posted negative returns. On a sector level, in terms of Euro credit, Financials and insurance continued to outperform other sectors such as Telecoms, Consumers and Transportation. Within the capital structure of financial credit, once again the riskiest tranches delivered strong performance, with Subordinated debt and AT1 (Contingent convertibles) leading the way as the only ones to deliver positive performance (along with corporate hybrids). With credit spreads tightening considerably on Risk assets, key segments are starting to run out of juice in the corporate bond universe.
The US HY market is showing improved fundamentals and the segment should benefit from balance sheet optimization and steady leverage levels, while profits should improve based on the expanding business cycle. Furthermore, supply does not appear to be an issue and the asset class is not facing a maturity wall. However, the sharp tightening in spreads on US HY has made it one of the most expensive asset classes in the current environment. A significant amount of good news appears to be priced in, namely a lower default rate (US default rates are set to decrease, and likely to reach 4% by the end of 2017) and higher energy prices as well as the expectations surrounding the potential tax reform. As a result, we are temporarily taking profits on this asset class.
We are continuing to overweight financials vs. non-financials, as financials enjoy better fundamentals and attractive valuations. The end of any additional QE and talks of probable tapering could impact have risk premiums on non-financial corporate bonds, causing spreads to widen (roughly 15 bps). 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 a new development in the regulatory landscape. A new tranche has arrived in the European bank capital structure (Tier 3). This bucket now includes Holdco Senior debt, non-preferred senior bonds and German Senior debt (which could move to the preferred senior debt category). This new classification will be incorporated in the benchmarks in February. In the financial sector, CoCos are still our favourite instrument. In terms of yield, they match the levels offered by US high yield credit.
Furthermore, the regulatory framework remains a key driver of spreads on bank contingent convertibles. Finally, stronger bank earnings are supporting the asset class, which also benefits from a low duration. CoCos have a weak correlation with US treasuries, which is attractive in the current environment. Technicals are also sound thanks to strong investor appetite (mainly asset managers, insurance companies and pension funds). However, we remain selective as the asset class may witness volatility due to specific events such as announcements of new regulations, and litigation risks on several banks. Extension risk has not been priced in to CoCos either (in terms of yield-to-maturity vs. yield-to-call).