Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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European credits: reality check needed.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: With Europe entering a recession and the ECB remaining on hold, euro-denominated corporate bonds remain at risk. The divergence between financial and corporate junk bond spreads following the SVB crisis suggests euro-denominated junk corporate bonds are trading too rich and within the last ten-year average. Since deterioration in the European credit space, excluding financials has been pronounced and poorly reflected in credit spreads, repricing is inevitable. We, therefore, remain defensive and favor quality.
After fighting negative rates in the euro area for years, European investors are looking at the junk bond space with interest and wonder whether it makes sense to lock returns now that the euro bloc is entering a recession.
European junk bond spreads have widened considerably since the ECB embarked on a rate hiking cycle. Junk corporate bonds denominated in euro pay a yield of 7.7% (including subordinated financial tranches), the highest since 2012, during the European sovereign crisis. The pickup that high-yield corporate bonds offer over high-grade peers rose to 350 basis points, a level well above average in the 2012-2022 decade.
At first look, the HY-IG spread has widened more significantly in Europe than in the US, where junk is paying only 300bps over investment-grade peers. However, digging deeper, one realizes that that's just an illusion.
Banks' junk bonds distort the picture when looking at corporate bond averages. Although junk-credit spreads have indeed widened considerably during the past three years, junk corporate bonds, excluding financials, are just paying 279 basis points over their investment-grade peers, less than what junk pays over quality in the US, and more or less in line with what we have seen pre-COVID pandemic.
Euro-denominated junk financial bonds are instead paying a whooping 650bps over their high-grade peers, the highest since 2012. The divergence between financial and corporate bond spreads has been clearly triggered by the SVB crisis in March.
When zooming in on European corporate bonds, excluding financials, we note that credit fundamentals have deteriorated broadly. That's a stark difference from what we see in the US, where certain sectors both in the investment-grade and high-yield space have been deleveraging while improving interest coverage since the COVID pandemic (for more information, click here).
Deterioration in the European junk bond space has been expansive, with only the basic industry sector improving leverage and interest coverage compared to pre-COVID averages.
The good news, however, is that the wall of maturities for the euro junk bond space doesn't start until 2025, removing some refinancing risk as the ECB remains on hold. Yet, as we enter 2024 and refinancing dates approach, financial markets will likely reconsider credit risk, causing a widespread widening of credit spreads.
Only companies in capital goods, transportation, and energy have seen an improvement within the investment-grade space, while leverage has been growing astonishingly among all other sectors.
At this juncture, deterioration continues to be the most likely path for corporates in the old continent. With Europe entering a recession and the ECB remaining on hold, credit spreads will likely widen in the upcoming months. Therefore, we favor quality over risk and remain defensive.
Here is an inspirational list of investment-grade euro-denominated bonds:
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