Macro: Sandcastle economics
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Cherry-picking crucial as bonds and equities bleed
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Increasingly hawkish central banks, political uncertainty, and falling stocks have pushed European high-yield corporates lower, but investors looking to make a move should remember the value of selectivity.
We have often looked at US financial markets and wondered whether the party is over and it is time to adopt a more defensive investing approach. We have rarely, however, spoken about the same happening in Europe. This year, however, will be remembered as a transition year as bonds from both the US and Europe have suffered losses across all rating categories, making it one of the worst years in the corporate bond space since 2008.
Now that we are approaching the end of 2018, I believe it is fair to look at the European corporate space and see whether these signs of distress point to something major, or whether it is time to buy lower-rated corporate bonds in order to ride the wave of tightening valuations that is going to follow.
The European high-yield corporate space has become incredibly cheap compared to US high-yield corporate bonds on a historical basis. On the graph below, the blue line represents the US high-yield OAS while the orange is Europe’s high-yield OAS. As you can see, this year is the first time since 2013 in which European high-yield option adjusted spreads widened above US high-yield OAS, signaling that there might be more value in European corporate names compared to their US counterparts
Now that we are approaching the end of 2018, I believe it is fair to look at the European corporate space and see whether these signs of distress point to something major, or whether it is time to buy lower-rated corporate bonds in order to ride the wave of tightening valuations that is going to follow.
The European high-yield corporate space has become incredibly cheap compared to US high-yield corporate bonds on a historical basis. On the graph below, the blue line represents the US high-yield OAS while the orange is Europe’s high-yield OAS. As you can see, this year is the first time since 2013 in which European high-yield option adjusted spreads widened above US high-yield OAS, signaling that there might be more value in European corporate names compared to their US counterparts
The widening of European high-yield corporate spreads can be explained by the headlines. For example, this year has seen Telecom Italia as one of the worst performers in the global bond market; its senior unsecured bond in EUR, with a 2033 maturity and paying 7.75% in coupon, has shrugged off almost 40 points in price, causing the yield to double from 3% to 6%.
Telecom Italia is a particular case where leadership instability has taken a toll on corporate debt performance, but the elements that placed the telecoms firm under considerable stress are the same ones that could cause a widespread weakness across other high yield corporates in EUR: weak fundamentals, political uncertainty, and central bank policies.
It is no coincidence that, apart from Telecom Italia, we have started to see other companies entering into ‘emergency mode’. Italian construction company CMC Ravenna, for instance, has announced that it will not be able to pay the coupon on its 2023 bonds. Outside of Italy, Nystar, Europe’s biggest zinc smelter, is also tumbling on poor Q3 earnings results and speculation on a possible debt restructuring.
To add to the list of European companies in difficulties, Renault’s CEO Carlos Ghosn has been arrested in Japan.
All these companies are certainly not helped by hawkish central bank sentiment, a falling equity market, and political uncertainty.
The role of central banks
Over the past five years, the European Central Bank has not only been instrumental in the recovery of the periphery, but in avoiding a larger European debt crisis that would have involved investors and creditors across all Europe. The policies of the ECB have supported asset prices, enabling even the most stressed corporates to survive as interest rates fell to historic lows and investors were progressively pushed to accept more risk in order to get higher returns.
As you can see in Figure 2, the Itraxx Crossover – an index that tracks the CDS contract performance of Europe’s most liquid sub-investment grade entities – has been rangebound since the ECB launched its purchase programme. This makes investors comfortable that valuations will remain supported until the ECB aggressively unwinds its balance sheet.
This leads to an overall tightening of European credit spreads and a considerable decrease of corporate defaults.
Given that the ECB said that it will not hike interest rates until the end of next year, it is reasonable to say that European high-yield corporates will continue to be supported in 2019. But does that mean that investors should continue to buy lower-rated corporate bonds even as prices fall?
In this environment, a change of strategy it is necessary, but this is easier to say than to do. Euro bond yields across all industries and ratings continue to be very low, and flying to safety implies leaving the high-yield space, where yields are currently low, for even lower yields in the investment grade space.
Telecom Italia is a particular case where leadership instability has taken a toll on corporate debt performance, but the elements that placed the telecoms firm under considerable stress are the same ones that could cause a widespread weakness across other high yield corporates in EUR: weak fundamentals, political uncertainty, and central bank policies.
It is no coincidence that, apart from Telecom Italia, we have started to see other companies entering into ‘emergency mode’. Italian construction company CMC Ravenna, for instance, has announced that it will not be able to pay the coupon on its 2023 bonds. Outside of Italy, Nystar, Europe’s biggest zinc smelter, is also tumbling on poor Q3 earnings results and speculation on a possible debt restructuring.
To add to the list of European companies in difficulties, Renault’s CEO Carlos Ghosn has been arrested in Japan.
All these companies are certainly not helped by hawkish central bank sentiment, a falling equity market, and political uncertainty.
The role of central banks
Over the past five years, the European Central Bank has not only been instrumental in the recovery of the periphery, but in avoiding a larger European debt crisis that would have involved investors and creditors across all Europe. The policies of the ECB have supported asset prices, enabling even the most stressed corporates to survive as interest rates fell to historic lows and investors were progressively pushed to accept more risk in order to get higher returns.
As you can see in Figure 2, the Itraxx Crossover – an index that tracks the CDS contract performance of Europe’s most liquid sub-investment grade entities – has been rangebound since the ECB launched its purchase programme. This makes investors comfortable that valuations will remain supported until the ECB aggressively unwinds its balance sheet.
This leads to an overall tightening of European credit spreads and a considerable decrease of corporate defaults.
Given that the ECB said that it will not hike interest rates until the end of next year, it is reasonable to say that European high-yield corporates will continue to be supported in 2019. But does that mean that investors should continue to buy lower-rated corporate bonds even as prices fall?
In this environment, a change of strategy it is necessary, but this is easier to say than to do. Euro bond yields across all industries and ratings continue to be very low, and flying to safety implies leaving the high-yield space, where yields are currently low, for even lower yields in the investment grade space.
Cherry-picking is fundamental
Although the economic environment for high-yield corporate bonds is becoming challenging, there are always opportunities in the high-yield corporate space, particularly with companies that are rated partly high-yield and partly investment grade by various agencies. This might as well be true for Telecom Italia, for instance, where prices have corrected intensively amid news, but the biggest risk remains downgrade rather than default.
Investors should keep in mind that a slowdown in European growth could lead leverage ratios to increase while debt reductions become more challenging. This implies that a deterioration of this space is very likely with valuations expected to fall further in the next couple of years.
This is why it is fundamental to make decisions that give investors the flexibility to wait until maturity, avoiding bonds from default-prone entities at all cost.
Although the economic environment for high-yield corporate bonds is becoming challenging, there are always opportunities in the high-yield corporate space, particularly with companies that are rated partly high-yield and partly investment grade by various agencies. This might as well be true for Telecom Italia, for instance, where prices have corrected intensively amid news, but the biggest risk remains downgrade rather than default.
Investors should keep in mind that a slowdown in European growth could lead leverage ratios to increase while debt reductions become more challenging. This implies that a deterioration of this space is very likely with valuations expected to fall further in the next couple of years.
This is why it is fundamental to make decisions that give investors the flexibility to wait until maturity, avoiding bonds from default-prone entities at all cost.
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