The zombification of European corporates. A top-down analysis to better identify credit opportunities
Fixed Income Strategist
Summary: Beware of zombies! As leverage rises to a record level, it becomes indispensable to cherry-pick corporate risk. In this analysis, we attempt to identify sectors and countries which offer the best risk-reward ratio for euro corporate bonds. High-grade credits paying above average can be found in the Consumer discretionary space, particularly in the automotive sector. The countries to offer the best opportunities are Austria, Ireland, Italy and Spain. In the junk space, healthcare corporate bonds offer exciting rewards. The most expensive places to shop for high yield bonds is Italy, Sweden and the Netherlands, while Belgium is one of the best.
This year's strategy for European bondholders is clear: maximum duration to benefit from the European Central Banks' accommodative policies as risk premia get squashed.
The message has arrived loud and clear to borrowers who have lost no time to issue ultra-long maturities taking advantage of ultra-low interest rates. Yesterday, France issued bonds with 50-years maturity for the first time since 2016. Demand was over the roof as the country received the highest number of orders ever at EUR 75bn. High demand pushed the issued spread down by 2bps from initial guidance. The pick-up that inventors earned by taking extra five-year maturity from the old OAT 2066 was merely 7bps. To many, the pick-up between the old and the new 50-years French bonds looked chunky, especially considering that there is only 10bps pick up to extend the maturity by 20 years.
France is not the only borrower to have taken advantage of historic low yields. In only three weeks since the beginning of the year, 19 bonds have already been issued with thirty years or longer maturity. The State of North Rhine-Westphalia in Germany, for example, has issued EUR 2bn of 100-year bonds.
Investing in bonds with long duration might be a strategy that pays off in the sovereign space. However, does it make sense to add on duration in the corporate sector when risk is skyrocketing?
The chart below shows that since early 2000 until today, European companies' corporate leverage, excluding financials has risen to record levels, particularly during the Covid-19 pandemic. As risk increases in the corporate world, European corporates' average yield has fallen to a historic low. To give you an example, in 2014, the average yield to worse for European corporates was around 2%, while average corporate net debt to EBITA ratio was 2. Only six years later, net debt to EBITDA rose to 2.63 while the average corporate yield fell to 0.35%.
The chart below brings forward another critical point. Since the Global Financial Crisis in 2008 and central banks' intervention, corporate bond yields have failed to signal a rise in credit risk. Indeed, in the first part of the graph, it is possible to see some correlation between corporate leverage and yields. Nonetheless, since 2009, we can see that the higher the corporate leverage, the lower the yield. It shows how influential were central banks, to define the world in which we are trading now, where debt comes cheap, and risk is expensive.
Therefore, it is safe to say that while investors are eager to take more duration, credit risk has implicitly increased, creating an explosive mix in their portfolio. In this context, diversification becomes extremely important as much as risk selection.
European corporate bonds: technology credits offer safety while junk energy bonds could lead to exciting returns as we are heading toward a recovery
If you are looking for safety, you can find the best value in the automotive space, which offers a higher reward (around 43bps in OAS) for average corporate leverage. According to Bloomberg data, Nissan 2028 (XS2228683350) provides the highest yield of 1.77%, followed by Peugeot 2033 (FR0010014845 ) and Volkswagen 2038 (XS1910948675) offering 1.22% and 1.3% respectively.
However, investors can find the safest credits in the technology sector. Technology bonds offer the lowest leverage and an extremely high-interest coverage ratio. Nevertheless, quality doesn't come cheap, and the average OAS offered by Technology credits is of merely 12bps. The American Fidelity National Information Services offers euro bonds with maturity 2039 (XS1843436145) and a yield of 1.18%, yet its leverage is above its three times its peers. Euronet Worldwide 2026 (XS2001315766) offer slightly lower yield, but it has a low net debt to EBITDA and high coverage ratio.
Euro industrial bonds offer the worst risk-reward ratio paying an average of 24bps in OAS, but exposing bondholders to high leverage and low-interest coverage.
Euro Consumer&Discretionary and Healthcare credits offer the best risk-reward in the junk space with an average option-adjusted spread around 278bps and 206bps, respectively. Although their leverage is within the junk average, they benefit from a high-interest coverage ratio. Among the highest paying credits can be found the German Cheplapharm Arzneimittel 2028 (XS2243548273), which offer a yield of 3.7%.
Energy junk credits appear to be the worst: extremely high leverage and low interest coverage ratio. Yet, we believe that they could be an excellent speculative trade as commodities' prices rise with the recovery. Among the best-priced energy euro bonds is the American CGG Holding 2023 (XS1713465760) which offers a yield of nearly 6%.
Which countries offer the best and worst opportunities?
In the investment-grade space, Austria and Ireland offer the best credit opportunities. Good returns can also be found in Italy even though the average credit leverage is slightly higher than in other countries. Finland and France's corporates instead are among the most expensive.
In the junk space, Belgium offers the highest paying corporate bonds with the lowest net debt to EBITDA. Corporates in the United Kingdom are also offering a higher OAS, but they are significantly more leveraged than their peers, making credit selection and the fundamental analysis critical. Junk bonds from Netherland, Sweden and Italy are amongst the most expensive and the riskiest.