How to find positive return potential with limited risk when most euro bonds offer a negative return.

Last year saw the strong outperformance of all types of euro corporate bonds, pushing down their spreads to historical lows. As this was the same for the Bund yields, 46% of the industrial bonds belonging to euro investment-grade benchmarks currently offer a negative return. The ECB quantitative easing bond-buying program largely explains these low yields and spread levels. We think investors should respond by shifting into an area out of the scope of the ECB programs: the financial sector.

In our view, credit quality for the Eurozone financial sectors is good. Capital has increased, partly driven by regulatory requirements, and bad loan provisions have increased. Importantly, bank controls are increasingly performed by the new, common European supervisor, the ECB, which enhances credibility. The ECB is also supporting the banking system by providing access to cheap funding, supporting bank credit quality.

Last year the COVID-19 crisis led to a severe recession in Q2, which made the market fear a surge in company defaults that would negatively affect the financial sector. But the European Union and each euro government reacted by implementing powerful economic and financial supports to avoid such a crisis. Activity rebounded significantly in the second half and corporate defaults increased by far less than expected, and even decreased in some countries. For example, in France, company defaults reached their lowest level of the last 30 years due to government measures.

In our opinion, investing in subordinated bank bonds is attractive, if one is selective. For example, with recent volatility in Italian markets, we believe select issuers in that country are attractive. But more generally, financial credit is our preferred relative-value sector in Europe right now.