Cherry-picking crucial as bonds and equities bleed

Bonds

Althea Spinozzi

Fixed Income Specialist, Saxo Bank

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
US high-yield OAS (blue) vs. EU high-yield OAS (orange), difference (green, source: Bloomberg)
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.
 
Source: Bloomberg
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.
Disclaimer

The Saxo 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 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 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 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 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 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-sg/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Markets or its affiliates.

Saxo Markets
3 Church Street, #30-00
Samsung Hub
Singapore 049483

All departments are available 08:30 to 17:30 Monday to Friday.

Singapore

Saxo Capital Markets Pte Ltd ('Saxo Markets') is a company authorised and regulated by the Monetary Authority of Singapore (MAS) [Co. Reg. No.: 200601141M ] and is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Risk Warning to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as Margin FX products may result in your losses exceeding your initial deposits. Saxo Markets does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Markets does not take into account an individual’s needs, objectives or financial situation.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-sg/about-us/awards.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan. Please click here to view our full disclaimer.

This advertisement has not been reviewed by the Monetary Authority of Singapore.