Following the recent widening of the risk premium, and taking into account the substantial size of the credit market (more than € 2 trillion), Euro IG and HY appear more attractive in the current environment of low (and, in fact, even negative) expected returns. The investment grade market has clearly changed and improved in terms of country and sector diversification over the last 10 years. Fundamentally, corporates are in good shape and, after years of cautious spending, have strong cash balance sheets, lower leverage and restored margins. European assets have become more popular with the continued support of the ECB (until the end of 2018 at minimum). Lastly, a cheaper hedging cost than the dollar is attracting a greater level of foreign assets such as those from Japanese Investors.
US corporates are delivering strong earnings results thanks to the “Job Act & Tax” effect. While leverage has stabilized, earnings grew by 23% on average. However, idiosyncratic has risen in the US. Though the energy sector is benefiting from higher commodities prices, retail and media are facing some secular challenges with the prominence of e-commerce. Furthermore, the psychological threshold of 3% on US 10-year treasuries weighed on risky assets. Finally, for a European investor, the cost of hedging is eating into some of the yield advantage. As result of higher yields and wider spreads year-to-date, the IG credit total return is negative (-3.5%). As a result, we maintain a cautious view on US IG as we think risk premiums could continue to widen, helped on by its maturing economic cycle and ripe political risks.
We continue to overweight the financial sector vs. the non-financial sector, which is currently benefiting from better fundamentals and relatively attractive valuations (though spreads, narrowing rapidly, are at low levels). The financial sector is also supported by improving capital reserves (and asset quality), better margins on the back of rising interest rates, and the regulatory landscape. Moreover, Q4 earnings confirmed the strength of bank balance sheets
Within the financial sector, CoCos remain our instrument of preference, benefiting, as they are, from earnings recovery, lower duration and a weaker correlation to US Treasuries.
With credit spreads at tight levels in both the IG and HY space, convertible bonds are an interesting source of diversification in the current environment. Convertibles could benefit from the upside that equity markets, supported by the better macro context, present and they have lower sensitivity to rising rates than traditional corporate bonds. We believe that European convertibles offer good value as European equities have lagged during the current phase of expansion and there is significant upside in the asset class.