European credit: upping the quality

The above is an extract from our Q3 Active Fixed Income Outlook.

The past: what just happened?

The European Central Bank (ECB) delivered its first quarter-point cut to 3.75% in June, but it fell short of promising any further reductions for the time being. That may have been because of the accompanying hawkish upgrade in both growth and inflation forecasts for the remainder of 2024. The central bank stressed the need for data-based decisions and for a meeting-by-meeting approach, thus limiting any forward guidance, which investors were hoping for.

Over the quarter, euro investment grade (IG) spreads continued to tighten, while all-in yields remained attractive, offering more than 100 basis points (bps) over the risk-free rate. While inflows into euro investment grade credit continued, issuance picked up, especially in reverse Yankee bonds (those issued by US companies denominated in a currency other than the dollar), as they were keen to tap the euro market and diversify funding sources.

The present: key themes

We believe European IG credit still looks attractive compared to history and alternatives in terms of spreads and yields when you look at the current percentiles*. At the same time, interest-rate risk is limited due to a duration of about 4.5 years. The latter point we believe is important as, with the spike in inflation over recent years and its sticky nature, with recent upside surprises to services inflation and wage negotiations, we remain humble in our ability to predict price increases and interest-rate trends.

We maintain a more cautious stance on the back of the strong compression between higher and lower quality already seen in the first half of 2024. While we expect a supportive technical backdrop to continue for European IG credit, the premium offered on new issues has largely disappeared

Both developments, we believe, warrant a more cautious approach with regards to adding further risk and new names to portfolios.

In terms of positioning, we maintain our bias towards quality, without giving up too much carry in our portfolio, to maintain sufficient yield versus the benchmark. This has been done primarily by avoiding bonds that we believe are too expensive and carefully selecting debt in the lower-rated part of the market. We continue to reduce our exposure to banks due to the spread compression versus corporates, as described in our recent blog.

Within sectors, we are overweight defensive areas such as utilities, which are trading at a premium partly due to heavy issuance amid capital expenditure linked to the energy transition. By contrast, we have an underweight position in cyclical areas, especially the automotive sector, on account of the prevailing structural issues related to electrification and heightened tensions between Europe and China over tariffs within the electric vehicle market.

What could go wrong?

Following the snap election called by President Macron, we anticipate that power wrangles between political parties will lead to headline risk and renewed bouts of volatility in financial markets.

Another potential headwind is a widening of credit spreads and a subsequent flight to safety, which may be exacerbated by the increasing popularity of the asset class.

Outlook

The dispersion between sectors and issuers, combined with political turmoil and economic uncertainty, offers opportunities for active management, in our view.

As Colin Reedie has already noted, while “two cycles are never the same”, we continue to leverage top-down macroeconomic analysis and combine it with bottom-up research from the credit research team. This, we believe, can help us better understand where we are in the economic cycle, while keeping a close eye on valuations. It is this tried-and-tested process that helps us to select issuers and sectors which offer superior risk-return characteristics and to construct robust portfolios.

The above is an extract from our Q3 Active Fixed Income Outlook.