Uncovering Value: The Strength of European Investment-Grade Bonds Uncovering Value: The Strength of European Investment-Grade Bonds Uncovering Value: The Strength of European Investment-Grade Bonds

Uncovering Value: The Strength of European Investment-Grade Bonds

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • Attractive Yields and Potential Spread Tightening: Despite tight credit spreads, European sovereign bonds offer value due to their still attractive yields and the potential for further spread tightening as the ECB gradually cuts rates, enhancing bond prices.
  • Resilient Credit Fundamentals: Solid corporate fundamentals and low default rates in the European investment-grade space reinforce the attractiveness of corporate bonds, offering stability even as credit spreads remain tight.
  • Top Five Standouts in the European Corporate Space: Companies like Orange, Ferrari, Volkswagen, and Imperial Brands have maintained strong credit profiles through disciplined financial management, strategic investments, and robust earnings, making them attractive in the European investment-grade corporate space even as spreads remain tight. Entities such as EDF benefit from government backing and strategic market positioning, which not only stabilize their credit profiles but also offer potential for further improvements.
As the ECB gradually cuts rates, the bond market could experience further bull steepening of the yield curve, which would likely boost bond prices and lower borrowing costs, thereby strengthening corporate bond fundamentals. Consequently, the outlook for European investment-grade corporate bonds in the second half and final quarter of the year remains promising, with multiple factors indicating the potential for continued positive performance:

1. Yield and Spread Environment:

Investment-grade bonds are poised to benefit from a strong carry and the potential for tighter spreads. Although spreads have tightened from their peak, they remain appealing, particularly as the European Central Bank (ECB) prepares to cut rates. Currently, spreads hover around 110 basis points, which is still attractive compared to recent highs, and could tighten further.

Investors may continue to be drawn to the European investment-grade corporate space due to the attractive yields, which remain well above the 15-year average. Additionally, with expectations of a soft landing, the ECB may not cut rates as aggressively as the market anticipates. This could mean that the bond market narrative might echo that of 2022 and 2023, where building a buffer against elevated inflation proved to be a successful strategy. Investment-grade corporate bonds offer a yield premium over sovereign bonds while keeping investors insulated from the higher default risks associated with junk bonds.

2. Credit Fundamentals:

Despite noticeable deterioration across the corporate bond spectrum compared to the pre-pandemic era, credit fundamentals in the investment-grade european space are proving resilient. Average corporate leverage, measured as debt over EBITDA, stands at 2.5x—higher than pre-pandemic levels but below the peak reached during Covid. Although average interest coverage dipped below 10x in the last quarter of 2023, there have been encouraging signs of recovery since then.

Credit upgrades (rising stars) are outpacing downgrades (fallen angels) by a substantial margin of 4 to 1, indicating strong overall quality in European investment-grade bonds. For context, the upgrade/downgrade ratio at the end of the last quarter of 2023 was much lower, around 1.36. As a result, default rates are expected to remain low, providing confidence to investors seeking solid returns in a more stable environment.

Top Five Standouts in the European Investment-Grade Market

1. Orange

The multinational telecommunications company has a strong credit profile that may improve further due to several key factors:

  • Low Leverage: Orange consistently keeps leverage at or below its 2x target, lower than many peers, preserving its BBB+ rating with potential for an upgrade.
  • Selective M&A: Orange focuses on smaller, strategic deals, avoiding the high leverage that often accompanies large acquisitions, protecting its credit rating.
  • Resilient Earnings: Steady earnings, particularly in France and Africa, and effective cost management bolster Orange's credit profile.
  • Market Confidence: Tight bond trading reflects strong market confidence in Orange's creditworthiness, supporting potential for a rating upgrade.
  • Related Bond Instruments: Orange bonds with 2033 maturity (FR0000471930) pay roughly 3% in yield and carry a coupon of 8.125%.
2. Ferrari

The luxury car maker has a strong credit profile with potential for further improvement due to several key factors:

  • Exceptional Margins: Ferrari's business model, with a staggering €181,000 EBITDA per car, reflects its strong pricing power and efficient operations, making it far less cyclical compared to peers like Porsche and BMW.
  • High-End Clientele: Ferrari caters to a high-net-worth customer base, allowing it to maintain stable cash flows and less dependency on external financing, which supports its financial stability.
  • Selective Production: By limiting supply and maintaining exclusivity, Ferrari preserves its brand value and residuals, leading to high margins and solid market positioning.
  • Low Leverage: Ferrari's net leverage is at an all-time low of 0.0x, giving it a strong balance sheet and the capacity to weather economic downturns better than competitors.
  • Market Leadership: Ferrari's brand strength, bolstered by a 43% surge in brand value, positions it as a leader in the luxury automotive sector, with a strong outlook for continued growth.
  • Related Bond Instrument: Ferrari bonds with 2030 maturity pay roughly 3.2% in yields (XS2824763044).

3. Imperial Brands.

The British multinational tobacco company has a solid credit profile with potential for improvement due to the following factors:

  • Low Leverage: Imperial Brands has achieved a net leverage of 1.9x, below its target range of 2-2.5x, which is lower than many of its peers. This disciplined approach to debt management supports its investment-grade credit rating and provides stability.
  • Sufficient Liquidity: Imperial has strong liquidity, with $1.6 billion in cash and $4.5 billion available under credit facilities. The company's stake in the Logista distribution business adds an extra layer of financial flexibility, which it has previously used for debt reduction.
  • Focused Strategy: While Imperial has less exposure to next-generation products (NGPs) than its peers, it is actively working to expand its presence in key markets. This strategy, combined with its conservative financial management, could improve its credit profile as it continues to strengthen its NGP portfolio.
  • Debt Refinancing: The company's recent bond issuances, aimed at refinancing existing debt, could lead to tighter spreads, reflecting improved investor confidence.
  • Related Bond Instrument: Imperial Brands in eur with maturity January 2025 (XS1558013360) pays roughly 3.6% in yield.

4. Volkswagen.

The German car maker maintains a solid credit profile with potential for improvement due to the following factors:

  • Significant Scale and Market Position: VW's massive scale, diverse product lineup, and broad geographic reach provide a strong foundation, differentiating it from peers and helping to secure its A3/BBB+/A- ratings.
  • Strategic Investment in EVs and Technology: VW's substantial investment in electrification and software, although costly in the short term, positions the company for long-term market leadership in the growing electric vehicle (EV) sector. As these investments begin to pay off, they could strengthen VW's credit metrics.
  • Financial Discipline and Cost-Cutting Measures: VW is implementing a €10 billion cost-saving plan by 2026, which should help improve margins and provide financial flexibility in a competitive market. This focus on efficiency and profitability could enhance its creditworthiness over time.
  • Cautious Approach to Corporate Actions: VW's decision to avoid further spinoffs or financial engineering projects reduces event risk, contributing to a more stable credit profile.
  • Related Bond Instrument: Volkswagen 2026 bonds pay roughly 3.2% yield and carry a coupon of 4.5 (XS2694872081).

5. Electricite de France (EDF).

The French energy company has a strong credit profile with potential for improvement due to the following factors:

  • Earnings Recovery: EDF's EBITDA surged to a record €40 billion in 2023, recovering from a loss of €5 billion in 2022. This recovery is expected to stabilize above €30 billion through 2025, providing a strong financial foundation.
  • Leverage Reduction: EDF's adjusted leverage has significantly improved, dropping to 2.3x in 2023, with expectations to maintain it around 3x, well below the 4x ceiling. This financial discipline enhances its creditworthiness.
  • State Support: The French government's backing has been crucial, especially during EDF's nationalization. This support, coupled with a positive outlook from S&P, strengthens EDF's credit profile and could lead to an upgrade.
  • Strong Liquidity: EDF has solid liquidity with €31 billion in resources, which comfortably covers its funding needs and supports its ongoing capital investments.
  • Related instruments: The EDF bonds with maturity 2030 (FR0010891317) offer a yield of roughly 3.3% and carry a coupon of 4.625%.

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