In our three decades working in European fixed income markets we have rarely if ever seen the same level of overseas interest in the asset class that we do today. Investors based in U.S. dollars and Japanese yen have become particularly engaged with the opportunity in euro-denominated investment-grade bonds. This can be explained partly by the difference between short-term interest rates in the euro zone and the U.S., which generates gains for hedging euro exposures back to dollars, and partly by the steepness of euro zone yield curves relative to the flatness of the curves in other developed markets.
But are the fundamentals of the euro investment grade market equally as attractive as this extra yield and currency carry? And are there particular pockets that we would pick out for a good combination of attractive yield and risk mitigation?
Our colleague, Anthony Woodside, wrote recently for our dollar-based readers about the opportunity in USD-hedged global treasury bonds. As he explained, three years of policy tightening by the Federal Reserve has made U.S. short-term rates the highest among the G10. That translates into higher hedging costs for foreign investors who buy U.S. debt and hedge out the USD risk, but for investors who have U.S. dollars, hedging away G10 currency exposure has resulted in gains. Interest rate differentials can change, of course, but over the past couple of years, for EUR and JPY bond investments, those gains have amounted to as much as 300 basis points per annum—just for hedging out non-USD currency risk.
In addition, because euro zone short-term rates are so low or even negative, euro zone yield curves are relatively steep. This is because the European Central Bank (ECB) has to focus its policy interventions at the short end of the curve, and there is less structural pension fund demand at the long end than there is in the U.S., U.K. and Japan. This creates an additional incentive for USD-based investors to go there for longer-dated yield: the flat U.S. curve currently means that a USD investor has to venture out as far as six or seven years to get paid any compensation for lending longer. It can also benefit JPY-based investors in EUR bonds: while JPY short-term rates are very low, generating less of a gain from hedging away EUR exposure, the Japanese yield curve is even flatter than the U.S. yield curve.
Especially for longer-dated exposure to developed market investment grade risk, EUR bonds appear remarkably attractive relative to the alternatives.
Technical Support, Fundamental Recovery
Generally, it is prudent to assume that extra yield comes with extra risk. We find it difficult to justify the differentials based on our current views, however.
Technical support for the market remains considerable. The ECB has extended its forward guidance on policy rates—hikes are not expected until 2020—and while it has ended its bond purchasing program, it is still reinvesting the proceeds of the bonds it holds. That reinvestment amounts to €16.5bn a month, which would cover almost all the net issuance of Germany or a large part of the net issuance of France. Moreover, the ECB and national central banks continue to buy every name in the EUR corporate bond universe.
Clearly, this reflects concerns about growth and inflation. However, whereas five years ago those concerns were homegrown as the euro zone recovered from crisis, today the risks are external. While we believe there is still risk priced into Italian government bonds due to ongoing tensions with the European Union over budget constraints, the broader dislocation between northern and southern markets has now dissipated. Improving economic performance and business confidence in France, Belgium, Spain and Portugal has led to a large fall in unemployment, which has supported resilient domestic consumption throughout the region.
The Euro Zone’s Domestic Strength
Lower unemployment leading higher wages
The consumer recovery
Source: Bloomberg. Data as of June 2019.
Externally, the dollar, tightening global financial conditions, the China slowdown, Brexit, collateral damage from the U.S.–China tariffs and the potential for the auto sector to be dragged into trade disputes are all significant threats. Moreover, they represent a very new kind of threat to the region, creating headwinds for the global exporting sectors and countries, such as the German auto sector, that have been Europe’s growth powerhouses for years.
At Neuberger Berman our central scenario remains one of eventual accommodation on the most immediately disruptive U.S.–China trade issues. In the event of broader tariffs, we believe that demand for Europe’s high-quality products is unlikely to be very pricesensitive and that most manufacturers will be able to adjust their strategies and locations over the medium term. In the short term, support will come not only from the ECB, but also from Europe’s capex cycle. Germany’s output gap has now closed. Elsewhere, many companies have been delaying or cutting capital expenditure over recent years, and we think an investment recovery is likely regardless of global conditions. We see signs of readiness for that capex expansion in the current 3% per-annum growth in corporate loan activity.
Against that background, in our view we would expect real yields to recover from their current level of -1% to +1%, and for the German Bund yield to edge back to around 50 basis points. In terms of asset and curve allocation, to us that suggests maintaining a bias toward credit-spread sectors versus core government bonds, and being slightly short duration, mostly from avoiding the 7- to 10-year part of the curve, with corporate credit in the 3- to 7-year bucket and inflation-linked and southern euro zone debt at the long end, to take advantage of keen valuations and curve steepness.
Cautious Corporates, Bolstered Banks
When we turn to the fundamentals of euro-issuing corporates, we find that leverage has been kept quite stable since the financial crisis despite a decade of slow growth. Today net debt-to-EBITDA stands at 1.35x, and the low rates of recent years mean that interest rate coverage has risen to record levels even as this leverage has been maintained.
Non-financial Corporate Leverage Has Been Declining
Source: Bloomberg. EuroSTOXX 600 Non-financials. Data as of December 31, 2018.
Europe’s banks, which make up around 40% of the investment grade universe, have seen their credit fundamentals improve significantly after a slow initial response to the financial crisis. Euro zone banks’ average core equity tier-1 capital has gone from 10% to 14% in the last five years. In the U.K. it has risen from 11% to 15%. Liquidity positions have also improved, leaving banks much less reliant on the wholesale funding that ceased so abruptly a decade ago. Euro zone banks have made a lot of progress cleaning up their balance sheets, with the ratio of the most problematic non-performing loans declining substantially since 2015. Few outside of Italy have exposure to Italian government bonds, the one market still struggling with the wide spreads of the euro zone crisis.
These and other cost-cutting measures have not been good for bank profitability, but that is a problem for shareholders rather than bondholders.
Europe’s Banking Sector is on Surer Footing
Core equity tier-1 capital ratio, fully loaded, U.K. banks
Core equity tier-1 capital ratio, fully loaded, euro zone banks
Liquidity versus wholesale funding
Non-performing loans ratio
Source: EBA, Neuberger Berman. Data as of March 2019 (Capital ratios) and December 2018 (Liquidity, NPL ratios).
Potential Value in BBB Credit
That is the case, as we see it, for EUR-based investors to stay with their domestic investment-grade fixed income market and for global investors to take a good look at it. But we also think there is a strong case for taking an active approach to this market because there are several clear value opportunities on offer.
As we mentioned, we think it is an opportune time to favor credit spread sectors over core government bonds. Even after a strong bounce in the first half of this year, EUR credit spreads still trade around their historic average levels, which we consider close to fair value. We expect plenty of technical support at these levels, given the ECB’s QE reinvestment policy and the general search for yield in an environment with negative interest rates on cash.
European Investment-grade Credit Spreads Are Back at Their Historical Average
Source: Bloomberg. Data as of May 31, 2019.
The medium-term predictability of that policy also focuses our minds on carry and rolldown as a source of added value rather than price volatility, and credit curves are steeper than core government curves.
That also informs our focus on A and especially BBB rated credit, where the available carry is most generous, particularly after a recent period of relative underperformance. While the past year has seen a lot of concern expressed over the growth of the U.S. BBB market, which has been driven by downgrades of household names, the European BBB market has a very different profile. Growth here has come largely from companies turning to the bond markets to complement their historic reliance on bank loans: BBB has long been the natural center of gravity for European corporate ratings, and ratings in this sector have been stable for some time, with very few on negative outlook with the rating agencies today. That reflects the caution with which many European companies have been run since the twin crises of 2007–09 and 2010 –2012. We would counsel greater care when it comes to some of the more highly leveraged retail and real estate companies that have done most of their issuance since the ECB started purchasing bonds.
We would expect a preference for credit over core government exposure to work through into a marginally short duration position. Credit allocations in the three- to seven-year maturity bucket and some keenly valued inflation-linked and southern euro zone exposure at the very long end of the curve can balance an underweight or short at the 7- to 10-year point that is most sensitive to the Bund yield. That is a duration position we would be happy to maintain at present.
Markets On the Margins: Brexit Britain and the Post-Crisis South
Regionally, we see opportunity in the southern euro zone now that crisis volatility has worked itself out from most of these markets. Credits in Spain and Portugal perhaps present the broadest opportunity, but we also see value in Italy despite being more cautious about sovereign risk there. Short-dated government paper arguably prices in too much immediate risk, as does some senior bank debt. In line with the current general undervaluation of inflation-sensitive assets, inflation-linked bonds from both the Italian government and Italian utilities may be worth a look. For example, Enel, Europe’s biggest utility company, which derives 40% of its revenues from outside Italy and its Italian revenues from highly stable network assets, currently trades at the price of a low-BBB credit rather than the high-BBB name we regard it to be due mainly to perceived sovereign risk.
It is also a good idea to remember that around half of the EUR bond issues of recent years have come from companies that are not based in the euro zone. These companies have come for the lower yields, but they can still offer attractive prices to EUR credit investors familiar with their fundamentals. Among these non-euro zone issuers are several U.K. names, which, due mainly to Brexit uncertainty, are currently trading at discounts to what we would consider fair value. Opportunities in the U.K. utilities sector, in particular, stand up very well even when we stress-test them for a hard Brexit.
Finally, we would always encourage newcomers to the EUR investment grade market to consider a sector that is unique to that market—non-financial corporate hybrid securities. Hybrids are very long-dated but callable bonds whose coupon payments can be deferred just like dividend payments. For that reason, credit rating agencies count them as half equity and half senior debt, which makes them advantageous for issuers. We can find no example of a missed hybrid coupon, however, and that reflects the high quality of issuers: 50% come from large telecom and utility companies based in high-rated countries. The fact that credit agencies rescind the half-equity categorization at a hybrid’s first call date also acts as a very strong incentive for issuers to call these securities at that time.
Given these characteristics, we believe that hybrid spreads, which are well over four times the spreads of the same issuers’ senior bonds, on average, are excessive. That makes a lot of extra yield and carry available to investors just for moving down the capital structure of a high-quality issuer, as opposed to moving down to lesser-quality issuers—the average hybrid is rated BBB, whereas the average hybrid issuer is rated A. But we also think that spread compression is a possibility as more investors recognize the value embedded in these securities. Most are now included in the major EUR investment-grade benchmarks.
To sum up, we would identify four big themes for investors in EUR investment-grade bonds to keep in mind: (1) the attractiveness of credit over core sovereign exposure, especially BBB bonds; (2) the availability of select, high-conviction southern euro zone value opportunities; (3) U.K. issuers of EUR bonds; and (4) non-financial corporate hybrids.
Behind these ideas stands our view that Europe’s incipient recovery will continue through this year, supported by an accommodative stance from the ECB; and that the risks associated with Brexit and the southern euro zone remain overstated in the way certain sectors are priced.
We believe these represent good active opportunities for EUR-based investors. Combined with the EUR bond market’s relatively steep yield and credit curves, and the potential gains from hedging euros back to dollars, they may also be of interest to non-domestic investors who have not considered this market in the past.