It was another good year for European investment grade and high-yield bonds, which outperformed US counterparts. Nonetheless, 2014 is unlikely to produce such a stellar performance as yields hit low levels.

January 2014

Key points

  • 2013 another favourable year for credit displaying surprising resilience in face of number of sovereign issues.
  • General fall in systemic risk, Europe exited recession and monetary policy remained supportive.
  • From total return perspective Europe outperformed us in investment grade and high-yield markets.
  • Total return expectations for 2014 lower. We expect investors to “clip coupons”.
  • Government bond yields remain key risk in 2014.
 

European investment grade and high-yield bonds had a good 2013 as they overcame a host of economic and sovereign concerns, such as the Cypriot banking crisis. But there are some potential clouds on the horizon for 2014.

Overall investors drew comfort from receding systemic risks and the Eurozone's exit from recession. In 2013, from a total return perspective, Europe outperformed the US for investment grade bonds: +2.39%1 vs. -1.46%2 and high-yield: +10.31%3 vs. +7.42%4.

Meanwhile, euro zone inflation slipped below 1% and analysts expect it to remain at very modest levels for the next few years with no hike in euro zone interest rates until 2016 if not later.

While falling inflation is likely to prove supportive for fixed income assets over the short term it could pose political and economic risks.

Analysts’ forecasts point to euro zone economic growth of around 1%5 in 2014 with the UK potentially hitting 3%.

Strong demand for investment grade credits

Demand for investment grade bonds was strong in 2013 helped by negative net issuance with financials in particular seeing a wall of redemptions. We expect that to continue into 2014. Non-financials issuance could be a touch higher.

Corporate hybrids almost doubled in market size with €30.4 billion in issuance across British pound sterling (GBP), euro (EUR) and US dollars (USD)6. Despite their complexity, corporate hybrids have seen strong outperformance on a risk adjusted basis.

Moves to standardise these instruments should support their appeal to investors.

Investor chasing lower credit quality

Strong investor demand is seeing investment grade issuance becoming lower rated and longer dated. The primary market was a major cause for outperformance in 2013 and that should be echoed in 2014.

On the whole the European investment grade market showed signs of declining leverage levels. If economic growth becomes entrenched corporate treasurers might take actions supportive of shareholders rather than pursue balance sheet preservation. An increase in M&A activity could also pick-up in 2014.

No sign of rotation

For all the talk of a 'great rotation' into equities, we’ve seen little evidence of it happening and investor demand was relatively stable for bonds.  This could change if issuers decide to favour shareholders over bond holders.

Investment grade spreads are probably fair value at around 120 basis points (bps), leaving little scope for further tightening. Market volatility will likely stay subdued but we see further compression between wide and tight spread products. While still in positive territory total return expectations for investment grade credits are 1-3%.

With less 'fallen angels' and generally improving credit ratings, we expected the BBB universe to outperform. On a regional basis, euro zone peripherals-based corporates look more attractive than non-peripherals.

A key risk for 2014 could be rising government bond yields. However, we believe Europe will maintain an easing bias while the US Federal Reserve looks to reduce its asset purchases.

Improving fundamentals lift high yielders

Low volatility, low defaults and an improving economy saw the European high-yield market post another year of outperformance in 2013, rising 10.31%7.

We see this trend continuing in 2014 with global defaults below their long-term average.

Credit spreads still show a sizeable premium over fair compensation for defaults at 400bp. This is likely continue into 2014 due to yields being at record lows and with the threat of rising bund yields.

Returns are expected to decline to 4-6%.

New supply was plentiful in 2013 with around €67bn year-to-date in issuance and €75bn expected by year end8 and we foresee another bumper year in 2014. 

Watch out for growing leverage

Though refinancing is the main driver behind issuance, re-leveraging is emerging as a key trend. As such credit metrics are beginning to deteriorate, albeit from a relatively solid base,

This can be seen from growing issuance of lower quality rated bonds and rising leverage often associated with M&A activity.

Even though yields are at an all-time low, there are very few alternatives to high-yield bonds, which are still best placed to deliver positive returns.

Meanwhile, we believe single B rated bonds should outperform BB paper. It is therefore worth taking on extra default risk, particularly given low default rate expectations.

 

  1. BofA ML Euro Corporate Index
  2. BofA ML US Corporate Index
  3. BofA ML European Currency High Yield Index
  4. BofA ML US High Yield Index
  5. Source: BNP Paribas 
  6. Source: JPMorgan
  7. BofA ML European Currency High Yield Index
  8. Source: JPMorgan

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