European politics and European equities have already come under our editorial scrutiny this year; now it is the turn of European credit. Since the end of the European sovereign crisis, corporate bond spreads have been supported by positive technical factors.
Technical factors are elements outside the intrinsic value of the individual security that affect the price. This can be supply, demand or symbolic price levels. For Euro investment grade, the big support is the demand.
This includes robust inflows into the asset class, coupled with the decision by the European Central Bank (ECB) to feature corporate debt in its quantitative easing (QE) programme. The combination of greater inflows, which bolster bond prices, plus the removal of supply by the central bank, which creates scarcity, has proven favourable for corporate bond investors.
Since 2012, EUR103bn (£87bn) has made its way into European investment-grade funds, while the ECB has so far purchased EUR72bn of corporate debt as part of its QE programme. This supportive technical environment for bonds was further aided by the introduction of cheap funding for banks via the ECB’s long-term refinancing operations (LTRO) announced towards the end of 2011, tempering senior bank funding needs in the bond market. As a result, banks have been less likely to issue debt and the resulting constraint on supply has also helped support valuations.
This strong tailwind for corporates is likely to fade over the medium term, but should investors be concerned? I think not. The ECB recently announced its intention to taper its bond-buying programme from April, but crucially, it will continue to purchase EUR60bn a month until at least the end of the year. I do not expect corporate debt to be included in the taper as the inability to source sovereign debt should mean a reduction there first. By year-end 2017, the ECB will – at its current run rate – have accumulated almost EUR150bn of corporate bonds.
While flows into corporate bond funds had been supported by declining yields and, crucially, positive returns, fears of a reflationary environment in Europe are unwarranted in the shorter term, in my opinion. Core inflation remains stubbornly low and well below the ECB’s target of 2 per cent. If rates rise to reflect the stronger growth momentum in the region, I do not expect flows to turn negative.
But it is not the magnitude and rate of change that really matters. As yields rise slowly, spreads are supported by demand from insurance companies that look to reduce their asset liability mismatch at more attractive levels.
While technical factors may weaken at the margin, I believe fundamental factors will continue to support and justify valuations overall. Corporate balance sheets remain in deleveraging mode aided by the stronger macroeconomic backdrop resulting in upward ratings momentum and continued decline in default rates. Moody’s expects the European default rate to remain stable at about 2 per cent.
Against this backdrop, I see investment opportunities in two key areas: in lower-rated bonds within the investment-grade credit sector and in bonds that are lower down in the capital structure. On average, investors can achieve a pick up in spread of 120 basis points for moving a notch lower into BB-rated corporates from BBB corporates and can sometimes benefit from upward ratings migration.
Within the financial sector, JP Morgan Asset Management advocates moving down the capital structure to take on a little more credit risk to achieve higher returns, specifically in the insurance sector where subordinated bonds trade three times wider than senior bonds. The average spread of bank subordinated debt relative to senior is lower at two times. I expect both strategies to perform as investor inflows and robust ECB bond-buying continues.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
