An opportunity from dispersion in Europe?
While the European Central Bank (ECB) is focused on gradually pressing the brakes to tame inflation, its exit from quantitative easing will continue to shape credit markets and create opportunities and risks for investors.
- Volatility this year has improved valuations and yields in euro investment grade (IG) credit, while increasing dispersion across credit markets.
- This emerges, however, against a backdrop of much trickier supply and demand dynamics, as central banks, including the ECB, remove their accommodative policies and test economic resilience.
- Credit spreads will therefore likely remain under pressure this year, but further volatility could create potential opportunities that warrant close scrutiny of fundamentals.
The ECB’s retreat as a backstop?
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Mario Draghi, ECB president, July 2012.
From the time of Draghi’s famous speech, the ECB has provided a reassuring backstop to support European credit markets, whether fiscal through funding or monetary through asset purchases. As shown in Figure 1, the expansion of the ECB’s balance sheet through quantitative easing (QE) has kept a lid on spreads to relatively benign levels and trading within a range. The central bank’s balance sheet has grown to 64% of its GDP, compared to 37% for both the US and the UK1.
More recently, such accommodation was enhanced by the ECB stepping into the credit markets through its Corporate Sector Purchase Programme (CSPP) and as the buyer of last resort through its Pandemic Emergency Purchase Programme (PEPP). The ECB plans to stop net asset purchases at the end of June. As these support programmes are retired, how will markets react to this demand shift – the loss of a significant buyer of euro investment grade (IG) corporates – and could it drive further spread widening?
Figure 1: QE expansion puts a lid on spreads
Source: Bloomberg, Janus Henderson Investors, 3 June 2022. Government option-adjusted spreads for the ICE BofA Euro Corporate Index.
Another demand headwind could be through the maturing of Targeted Longer-Term Refinancing Operations (TLTRO) programmes. The scheme encourages banks to lend by offering access to cheap funding, allowing them to effectively borrow at a rate of as low as -1%. Despite some early repayments, the programme still has an outstanding volume of roughly EUR€2.2 trillion2 and the expiry of the discount on the TLTRO this month could encourage more early repayments. The departure of another significant buyer of government debt could have ripple effects on credit markets, particularly if it involves the selling of eurozone peripheral debt.
The ECB is focused on the smooth transmission of its monetary policy across the bloc and preventing market fragmentation, in other words divergence between weaker and stronger economies. Officials have hinted at a backstop to mitigate this risk. This was reiterated in the June meeting where ECB President Lagarde highlighted the scope of the flexibility of PEPP reinvestments, but also said “existing adjusted instruments or new instruments” could be deployed. Such signalling is as key – perhaps even more so – to sentiment and therefore price moves, as the action itself. Whether this is setting up another TLTRO, stepping in with last minute large asset purchases, a cap on periphery spreads or setting up a standing facility is up for debate. However, the signal may be enough firepower if it is credible, as it was with Draghi’s “whatever it takes” speech in 2012 and the emergency Outright Monetary Transactions (OMT) facility did not need to be used as the sovereign debt crisis resolved.
A sea change for IG credit
Nevertheless, it cannot be disputed that a significant liquidity withdrawal is in train with the ECB following other central banks in its tightening journey. The shape of demand will also change. CSPP eligible credits have benefitted from steady ECB buying and the lack of asset purchases could cause dispersion to rise. A good way therefore to quantify the impact of the end of QE on euro IG spreads – and thus the effect of its removal – would be to consider the ECB ineligible versus the eligible debt spread difference, as shown in Figure 2. Going forward, we expect more dispersion is likely between ECB eligible debt (euro IG bonds the ECB can buy as part of its asset purchase programmes) and non-ECB eligible debt, such as high yield and IG issued by bank corporations. More specifically, ECB eligible debt could start to underperform ECB ineligible debt, given that demand from the ECB is retreating.
As an aficionado in corporate QE, the ECB holds 16% of the euro IG market, compared to less than 1% for the US Federal Reserve and 5% for the Bank of England in their respective markets3. It is even higher when considering the restrictions around buying financial debt through the CSPP and PEPP, making the ECB the owner of a fifth of non-financial corporate bonds4. Its departure is thus significant and opportunities could emerge as spreads widen for ECB eligible debt. Eventually risk/reward profiles could reconnect more with fundamentals. The changing policy backdrop has already hugely influenced issuance trends.
Figure 2: Euro IG Non-ECB eligible versus ECB eligible spreads could tighten
Source: Credit Suisse, as at 25 May 2022.
Supply pressure on the release?
European credit came under increased pressure in early 2022, after the ECB tabled rate hikes earlier than expected. Volatile markets are not a good recipe for raising capital on the primary market, which has held up new issuance. Primary market activity slowed sharply in February and early March following Russia’s invasion of Ukraine but rebounded later in March. Following a quiet April, issuance has recovered strongly in May as IG companies rushed to raise capital during moments of stability. If volatility subsides, there will most likely be another supply headwind to contend with at a time when a significant buyer is exiting the market. This year, for example, the ECB has more than fully absorbed net issuance in euro IG5.
There could also be a rush to issue before corporate bond purchase schemes start to wind down or before tightening makes refinancing more expensive. A wall of supply – if it arises – could in essence make it difficult for IG credit to rally meaningfully. On the flip side, economic woes could encourage companies to refrain from borrowing or proactively de-lever to streamline balance sheets. An unfortunate side effect of fewer issues if supply dries up is less opportunity for investors to use the primary market as a gauge for fair pricing in the secondary market.
A sweetener for investors to participate in the primary market has been the small price discount – namely the new issue (yield) premium (NIPs) – to the issuer’s existing bonds in the secondary market. However, as supply has slowed the new issue premium has decreased compared to levels seen at the beginning of the pandemic (Figure 3). This means the secondary market could be more inviting to investors, particularly if pockets of spread widening emerge as the ECB joins the tightening party. Nevertheless, the average NIP has increased in May perhaps with more supply coming to market, but NIPs are only part of the story.
Figure 3: New issue premiums have been on a declining trend
Source: JP Morgan, 18 May 2022.
No more negativity
Discounts pale on the surface particularly if meagre when considered in isolation without absolute yield levels – a key barometer for the other side of the coin, investor demand. Yields on euro IG corporate bonds have climbed as a hawkish pivot towards tightening from central banks has pushed rate expectations higher. The yield on the ICE BofA Euro Corporate Index has risen from 0.5% at the start of the year to climb above 2.5% in early June (Figure 4). This surpasses the peak of 2.0% at the onset of the pandemic in March 2020 and comparable to levels seen in August 2012. Yields at the latter time were reflective of sentiment rather than bank rates – which the ECB started to cut – as investors demanded extra compensation for buying debt in Europe in the wake of the sovereign debt crisis. This time around higher yields are reflecting the pricing in of rate hikes and so as the ECB is yet to commence tightening and with economic growth softening, we believe we could see even higher yields emerge in Europe.
Figure 4: Yields now at levels seen during sovereign debt crisis
Source: Bloomberg, 7 June 2022. ICE BofA Euro Corporate Index.
A closer look at the underlying composition of the benchmark reveals that currently no bonds yield less than 0% in the euro IG universe (Figure 5). This compares to around 37-46% of the benchmark in negative yield territory in August last year. In fact, if we take a broader lens to consider global IG credit yields over the last decade, current yield levels are sitting around the 80-100% percentile6 and so are very attractive. This more positive yield profile broadens the opportunity for investors to enhance diversification.
Figure 5: No euro IG bond yields in negative territory
Source: Markit iBoxx, 27 May 2022. ICE BofA Euro Corporate Index.
Turning to spreads, while global IG spreads look more attractive on an absolute basis, they remain in a range close to 10-year historical averages6. It appears that markets are pricing in more on rates than spreads. Much of the pricing in of hikes is at the short end of the yield curve in tandem with a front-loaded tightening cycle. The ability to capture a positive yield in high quality short-dated paper may prove to be a positive demand dynamic for IG credit, particularly at a time when taking on too much duration – or interest rate sensitivity – may feel uncomfortable. However, we remain vigilant of spread vulnerability, as IG credit valuations undercompensate investors for recession risks. This is why in Europe a backstop from the ECB is being closely watched for and the central bank can only be gradual in tightening to mitigate fragmentation risk while tackling price stability.
Up the quality curve
Decompression – or the underperformance of lower-rated credit – is already occurring and we expect to see more of this as liquidity drains from the market. A defensive approach in moving up the quality spectrum – and favouring non-cyclical exposure given recession risks – therefore feels warranted.
Higher absolute yields could support demand for IG against a tricky supply backdrop, but we believe investors should focus on being adequately compensated for the risk taken as more spread widening could emerge. Going forward, as the most significant buyer of IG credit retreats from the market, we believe performance will be largely driven by strong bottom-up security selection based on fundamentals – i.e. through identifying bonds that offer attractive risk-adjusted returns for portfolios. Adopting a nimble approach to take advantage of bouts of increased volatility that lead to greater idiosyncratic dispersions or inefficiencies could help generate excess returns.
1 Source: Bloomberg, 29 April 2022.
2 Source: ECB, HSBC, Bloomberg, 25 May 2022.
3 Source: HSBC, 7 March 2022.
4 Source: Credit Suisse, 8 February 2022.
5 Source: Credit Suisse, 27 April 2022.
6 Source: Bloomberg, 10 June 2022. According to the ICE BofA Global Corporate Index.
Dispersion: This refers to the range of possible returns on an investment. It can also be used to measure the risk inherent in a particular security or investment portfolio.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment
Credit spread: The difference in the yield of corporate bonds over equivalent government bonds.
Quantitative easing: An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.
Investment-grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Corporate Sector Purchase programme (CSPP): The ECB’s purchase scheme of corporate sector bonds, where investment grade euro-denominated bonds issued by non-bank corporations established in the euro area are deemed eligible assets.
Pandemic Emergency Purchase programme (PEPP): The ECB's pandemic emergency purchase programme (PEPP) is a non-standard monetary policy measure initiated in March 2020 to counter the serious risks to the monetary policy transmission mechanism and the outlook for the euro area posed by the coronavirus (COVID-19) outbreak.
Targeted Long-term Refinancing Operations (TLTRO): The targeted longer-term refinancing operations (TLTROs) are Eurosystem operations that provide financing to credit institutions. By offering banks long-term funding at attractive conditions, they preserve favourable borrowing conditions for banks and stimulate bank lending to the real economy.
Credit: A marketplace for investment in corporate bonds and associated derivatives.
Standing facility: A central bank facility available to counterparties on their own initiative. The Eurosystem offers two overnight standing facilities: the marginal lending facility and the deposit facility.
The European sovereign debt crisis: This period saw the collapse of financial institutions, high government debt and sharp spikes in bond yields across some European economies.
Primary market: This part of the capital market where new securities are issued and become available for trading.
Hawkish: Indication that central bankers are looking to restrict money supply to achieve their policy objective.
Monetary policy: Central bank policies aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. See also fiscal policy.
Fiscal policy: Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.
Yield curve: A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
Cyclical stocks: Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.
Fragmentation: From a monetary policy transmission perspective, fragmentation can be viewed as the lack of full tradability of central bank reserves across borders which cannot be explained by technical or fundamental factors.
Bottom-up: This refers to a focus on the analysis of individual securities, in order to identify the best opportunities in an industry or country/region.