Euro IG credit, while relatively tight in terms of spreads, has been exhibiting strong company results and improving ratings. Furthermore, it is important to note that the share of issuance by non-Eurozone companies in Euro IG is increasing, making it a less “domestically dominated” asset class, as foreign companies aim to take advantage of easy financing in the euro area. The recent equity correction has led to higher volatility and the synthetic derivative markets saw sharp widening. However, cash bonds were relatively unaffected, as issuance has been relatively low (on primary markets).
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. 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. In terms of yield, these instruments match the levels presented by US high-yield credit.
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 present and are less sensitive 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.
The recently agreed-upon fiscal reform passed by lawmakers in the US appears to be favourable to IG corporates as a result of a lesser tax burden. However, the ability to increase dividends, engage in M&A, raise capex and deleverage will vary according to sector and competitive advantage (i.e., on a case-by-case basis rather than on a homogenous level). The fiscal stimulus favours equity more than bond holders and is, in fact, likely to increase discrepancy amongst issuers. Furthermore, the limits imposed by the new regulation in interest deductibility (max. 30%) will penalise high-yield issuers (mostly in the lower-rated CCC spectrum), who have higher interest payments. All in all, selectivity will be key, as idiosyncratic risks come to the forefront in terms of corporate bond-picking. On US credit, valuations continue to be tight and, as a result, we are maintaining an underweight stance, preferring, instead, to focus on EM debt.