Credit Markets appear to be expensive

The good performance of “Risk-on” assets and sovereign rates was also felt in the corporate bond universe as convertibles, global high yield and the emerging market asset class saw positive returns in February. The US high-yield market produced a stronger performance (and was in fact one of the top performers) than its European counterpart. The investment grade segments (both $ and €) also witnessed positive returns, though to a lesser extent. At sector level, in terms of Euro credit, all sectors delivered a positive performance, with Financials and Insurance outperforming sectors such as Telecoms, Consumers and Transportation. Within the capital structure of financial credit, once again the riskiest tranches delivered a strong performance, with subordinated debt and AT1 (contingent convertibles) leading the way (along with corporate hybrids), though all tranches delivered a positive performance.

Credit Markets appear to be expensive

Globally, the 2016 Q4 corporate results have been strong. Leverage is shrinking, the business cycle will restore EBITDA margins and interest expense charge coverage is better, thanks to a lower financing rate. On the technical front, supply has been quite strong, especially on Euro investment grade. With credit spreads tightening considerably on risky assets, key segments are starting to run out of juice in the corporate bond universe and appear increasingly expensive.  On the Euro high-yield asset class, for example, the current risk premium is at 340, well below the target spread of 380 bps. The asset class, however, continues to generate inflows, primarily as a result of a lack of alternatives. In the US, the default rate continues to decelerate, this time falling to 4.4% by the end of February, and valuations, after the strong spread tightening, are already integrating the better corporate fundamentals. In terms of alternatives, there could be a rotation from fixed to floater products but a large number of investors have restrictions. Another alternative could be to switch towards more higher-yielding products, like Emerging Debt.

Continue to favour European financial credit

We continue to overweight the financial sector vs. the non-financial sector, which is benefiting from better fundamentals and attractive valuations. The end of additional QE and talks of a probable tapering could affect the risk premiums of the non-financial corporate bonds, leading to a widening of spreads. However, the financial sector is 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 continue to be our instrument of choice. The asset class is benefiting from the earnings recovery, lower duration and weaker correlation to US Treasuries. The sub-set continues to perform well, supported by strong carry and the positive news from both the Italian and the German banking sectors. In terms of yield, these instruments match the levels presented by US high-yield credit. Technicals are also sound, as there is a strong appetite from investors, who are primarily asset managers, insurance companies and pension funds.  However, we remain selective, as the asset class could witness volatility as a result of specific events such as an announcement of new regulations, and litigation riskson several banks. The extension risk does not seem to be priced in, as the yield-to-maturity equals the yield-to-call.

Regarding the lower-tier 2 (LT2) segment of the capital structure, we note that short-dated papers are the bonds to have tightened the most, as the perception of extension risk has improved with the tightening of the market and the emergence of the senior non-preferred Tier 3 market. We notice that there is less pressure on supply as a result of the new Tier 3 tranche that came into existence in 2017 in order to fulfil regulatory requirements. Furthermore, the LT2 tranche also presents more attractive risk premiums than the rest of the corporate bond sectors.

Finally, on the relatively safer tranches, the legacy senior unsecured debt saw spread-widening as a result of political risks, and it was primarily the Italian and French banks that were hit. On the aforementioned T3 tranche, supply has been quite steady and we expect around EUR 100 billion of flows this year; the structure was recognized in the Markit benchmark end of February 2017.