GI Research Market Commentary
Euro area IG corporate bonds - Breaking out of the 4-month old trading range likely,
but total returns to remain low going forward
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Due to a the positive news flow, euro area IG corporate bond spreads are trading at the lower
bound of the 4-month old trading range.
The sound macroeconomic environment and the expectation that an extremist French president
will be avoided are likely to support corporate bonds going forward.
Low and further falling defaults in combination with ongoing ECB purchases are seen to trigger a
further spread tightening in the months to come.
Despite the expected spread tightening, the total return of corporate bonds will remain closely
linked to sovereign bonds. Hence, the total return is forecast to remain meager.
After euro area IG corporate bonds have remained in a tight trading range between 155 bps and 161 bps
for four months, they steadily narrowed over the last days. Meanwhile, spreads are trading on the tightest
level of the year. Therewith, they were able to partially shrug off the negative performance of European
sovereign bonds. Year-to-date the total return of euro area IG corporates is -0.2%, with financials
performing slightly better than non-financials (+0.1% versus -0.4%). This is low compared to other asset
classes but it shows that corporate bonds are able to withstand rising yields better than feared by many
market participants.
The benign development is to a large extent due to the recent news flow. To start with, the Dutch election
signalled a rejection of populism and a re-strengthening of pro-European parties. Second, recent polls
show that LePen’s lead in the first round of the French Presidential election is diminishing. Macron’s good
performance in the first TV duel yesterday indicates that he has a good chance to become the next French
president. The reform agenda put forward by the centrist candidate has soothed financial markets. Third,
the macroeconomic news flow continued to surprise on the upside and signals that the euro area’s
economic recovery has legs. Finally, although the ECB took a somewhat more hawkish tone recently, Draghi
stressed that the ECB will proceed with its QE program for the time being and a withdrawal of liquidity is
still a long way off.
Going forward, we see some scope for the recent trend to continue. The trailing 12-month default rate has
fallen from 2.3% to 2.2% in February. This is well below the long-term average of 3.8%. What is more, the
default rate is seen to fall below the 2%-threshold in the months to come and to remain there at least for
the remainder of 2017. Among other things, the corporate spread is a compensation for a certain default
risk. These numbers show that euro area IG corporate bonds are still attractively valued. This is recognized
by the rating agencies as well. The 12-month rating drift increased for the sixth consecutive month in
February to a long-term high. Given the cautious approach by European corporates and the benign
macroeconomic outlook a change of the trend is currently not in sight.
In addition, it is not clear whether the forthcoming monthly reduction of ECB purchases from €80 bn to
€60 bn will affect corporate bonds at all. The scarcity of government bonds necessitated already purchases
of sovereign bonds yielding less than the deposit rate and in some cases the central bank even reduced the
monthly amount (implying a deviation from the capital key). Hence, to circumvent the problem the central
bank could decide to maintain its current volume (around €8 bn/month). In any case, the ECB will continue
to take down a significant amount of new supply in the months to come – thereby supporting the
corporate bond market. We regard concerns about a tapering already in 2017 as overdone.
All in, assuming a centrist candidate will win the elections in May (the Dutch election being a welcome
harbinger), we see scope for euro area corporate bond spreads to tighten in the weeks to come. However,
although corporate bonds are expected to continue to perform better than sovereign bonds, the total
return is forecast to remain meager as the trend toward higher sovereign yields is likely to prevail.
Author:
Dr. Florian Späte, CIIA
[email protected]