The zombification of European corporates. A top-down analysis to better identify credit opportunities

This year's strategy for European bondholders is clear: maximum duration to benefit from the European Central Banks' accommodative policies as risk premia get squashed.

The message has arrived loud and clear to borrowers who have lost no time to issue ultra-long maturities taking advantage of ultra-low interest rates. Yesterday, France issued bonds with 50-years maturity for the first time since 2016. Demand was over the roof as the country received the highest number of orders ever at EUR 75bn. High demand pushed the issued spread down by 2bps from initial guidance. The pick-up that inventors earned by taking extra five-year maturity from the old OAT 2066 was merely 7bps. To many, the pick-up between the old and the new 50-years French bonds looked chunky, especially considering that there is only 10bps pick up to extend the maturity by 20 years.

France is not the only borrower to have taken advantage of historic low yields. In only three weeks since the beginning of the year, 19 bonds have already been issued with thirty years or longer maturity. The State of North Rhine-Westphalia in Germany, for example, has issued EUR 2bn of 100-year bonds.

Euro zombification

Investing in bonds with long duration might be a strategy that pays off in the sovereign space. However, does it make sense to add on duration in the corporate sector when risk is skyrocketing?

The chart below shows that since early 2000 until today, European companies' corporate leverage, excluding financials has risen to record levels, particularly during the Covid-19 pandemic. As risk increases in the corporate world, European corporates' average yield has fallen to a historic low. To give you an example, in 2014, the average yield to worse for European corporates was around 2%, while average corporate net debt to EBITA ratio was 2. Only six years later, net debt to EBITDA rose to 2.63 while the average corporate yield fell to 0.35%.

The chart below brings forward another critical point. Since the Global Financial Crisis in 2008 and central banks' intervention, corporate bond yields have failed to signal a rise in credit risk. Indeed, in the first part of the graph, it is possible to see some correlation between corporate leverage and yields. Nonetheless, since 2009, we can see that the higher the corporate leverage, the lower the yield. It shows how influential were central banks, to define the world in which we are trading now, where debt comes cheap, and risk is expensive.

Therefore, it is safe to say that while investors are eager to take more duration, credit risk has implicitly increased, creating an explosive mix in their portfolio. In this context, diversification becomes extremely important as much as risk selection.