European credits: reality check needed. European credits: reality check needed. European credits: reality check needed.

European credits: reality check needed.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  With Europe entering a recession and the ECB remaining on hold, euro-denominated corporate bonds remain at risk. The divergence between financial and corporate junk bond spreads following the SVB crisis suggests euro-denominated junk corporate bonds are trading too rich and within the last ten-year average. Since deterioration in the European credit space, excluding financials has been pronounced and poorly reflected in credit spreads, repricing is inevitable. We, therefore, remain defensive and favor quality.


After fighting negative rates in the euro area for years, European investors are looking at the junk bond space with interest and wonder whether it makes sense to lock returns now that the euro bloc is entering a recession.

European junk bond spreads have widened considerably since the ECB embarked on a rate hiking cycle. Junk corporate bonds denominated in euro pay a yield of 7.7% (including subordinated financial tranches), the highest since 2012, during the European sovereign crisis. The pickup that high-yield corporate bonds offer over high-grade peers rose to 350 basis points, a level well above average in the 2012-2022 decade.

At first look, the HY-IG spread has widened more significantly in Europe than in the US, where junk is paying only 300bps over investment-grade peers. However, digging deeper, one realizes that that's just an illusion.

Source: Bloomberg.

Banks' junk bonds distort the picture when looking at corporate bond averages. Although junk-credit spreads have indeed widened considerably during the past three years, junk corporate bonds, excluding financials, are just paying 279 basis points over their investment-grade peers, less than what junk pays over quality in the US, and more or less in line with what we have seen pre-COVID pandemic.

Euro-denominated junk financial bonds are instead paying a whooping 650bps over their high-grade peers, the highest since 2012. The divergence between financial and corporate bond spreads has been clearly triggered by the SVB crisis in March. 

Source: Bloomberg.

When zooming in on European corporate bonds, excluding financials, we note that credit fundamentals have deteriorated broadly. That's a stark difference from what we see in the US, where certain sectors both in the investment-grade and high-yield space have been deleveraging while improving interest coverage since the COVID pandemic (for more information, click here).

Deterioration in the European junk bond space has been expansive, with only the basic industry sector improving leverage and interest coverage compared to pre-COVID averages.

The good news, however, is that the wall of maturities for the euro junk bond space doesn't start until 2025, removing some refinancing risk as the ECB remains on hold. Yet, as we enter 2024 and refinancing dates approach, financial markets will likely reconsider credit risk, causing a widespread widening of credit spreads.

Only companies in capital goods, transportation, and energy have seen an improvement within the investment-grade space, while leverage has been growing astonishingly among all other sectors.

At this juncture, deterioration continues to be the most likely path for corporates in the old continent. With Europe entering a recession and the ECB remaining on hold, credit spreads will likely widen in the upcoming months. Therefore,  we favor quality over risk and remain defensive.

Here is an inspirational list of investment-grade euro-denominated bonds:

Source: Bloomberg and Saxo Group.
Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
- Full disclaimer (https://www.home.saxo/en-mena/legal/disclaimer/saxo-disclaimer)


Boulevard Plaza, Tower 1, 30th floor, office 3002
Downtown, P.O. Box 33641 Dubai, UAE

Contact Saxo

Select region

UAE
UAE

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

Saxo Bank A/S is licensed by the Danish Financial Supervisory Authority and operates in the UAE under a representative office license issued by the Central bank of the UAE.

The content and material made available on this website and the linked sites are provided by Saxo Bank A/S. It is the sole responsibility of the recipient to ascertain the terms of and comply with any local laws or regulation to which they are subject.

The UAE Representative Office of Saxo Bank A/S markets the Saxo Bank A/S trading platform and the products offered by Saxo Bank A/S.