By Laurent Gorgemans, Global Head of Investment Management at Nordea Asset Management
As European corporate bonds display yields not witnessed for many years, investors are casting a renewed eye on the region’s credit market. But while all segments of European corporate debt offer attractive yield levels relative to the past decade or more, investors must avoid complacency in the face of continued challenges.
High yield is understandably a primary area of focus for investors today, as yields on sub-investment grade credit remain elevated following the significant spike during 2022—EU HY has seen yields are sitting between 7-8% as of end Sept 2023. However, many of the lower-quality credits within this universe remain vulnerable to downside pressure, particularly considering ongoing economic uncertainties.
At the opposite end of the spectrum, yields for many of the highest-quality names within the investment grade space are unlikely to deliver a significant real return over still-elevated inflation. In fact, EU IG yields of presenting around 4-5%, in line with the ECB deposit rate, while bonds with a rating of AAA to A are presenting in the 4% range.1
One way for investors to overcome the current bitter-sweet credit conundrum is to isolate the middle band of European corporate bond opportunities – those rated BBB, BB and B. We believe corporate bonds on either side of the investment grade and high yield boundary – more commonly known as cross credit – are best placed to achieve robust real returns, while also offering a little cushion should we see additional economic turbulence or deterioration of sentiment.
Rating changes create inefficiencies
Due to its location on the credit spectrum, the cross credit space is renowned for inefficiencies stemming from actual or anticipated rating changes. While alterations to ratings result in investor allocation shifts across the whole market, activity heightens when an investment grade issuer becomes a fallen angel by dropping into high yield, or a junk bond name becomes a rising star by jumping into investment grade.
We have witnessed intensified re-grading action this year, with more than €400bn of European corporate debt experiencing a rating change as of the end of July – consisting of 30 fallen angels and 11 rising stars2. Such volume is above average relative to the last decade – lagging only the Covid-dominated year of 2020, when many companies were naturally downgraded, and the subsequent re-upgrading of many credits during the economic rebound of 2021.
With economic volatility tipped to persist for the foreseeable future, dispersion is set to continue featuring heavily in the cross credit space. This will bring opportunities for active investors, as it has done in the past. In fact, a cross credit portfolio constructed with one-third BBB-rated bonds and two-thirds BB-B debt has generated annualised returns of 5% close to the ICE Euro High Yield Index, which has delivered an ARR of 5.39% since 31.12.20003.
Expect increased focus on fundamentals
The end of the quantitative easing is set to provide another tailwind for active cross credit investors. Central banks were previously major buyers of investment grade issuers, with liquidity often spilling over into high yield. Intuitively, the withdrawal of the European Central Bank company-insensitive demand makes it more important to discern sound issuers from potentially weaker names.
Within high yield, it is true companies across Europe took advantage of the low cost of financing in recent years to significantly extend maturity profiles. With the next major refinancing walls arriving in 2025 and 2026, it could take a while for default rates to spike. However, spread levels tend to soar well ahead of default waves, which could catch out many yield-hungry investors.
In the search for balanced risk-adjusted carry, investors might also consider avoiding the high-beta banking and insurance industries. Even though banks and insurance companies offer attractive opportunities for an active bond investor, such names are prone to large price changes and sudden repricing. This was clearly evident during the SVB and regional bank episode in the US, as well as with Credit Suisse in Europe, earlier this year.
With eye-catching yields ranging from 4-8%1 still on display, corporate bonds and other areas of fixed income are likely to lead investor demand as we move towards a new year. But with drawbacks at each end of the spectrum, it is understandable if capital increasingly seeks a home within the sweet spot of spread and duration risk offered by the cross credit space.
For investors interest in corporate bonds on either side of the investment grade and high yield boundary, NAM offers a European Cross Credit Strategy. Managed by Jan Sørensen, the solution invests in the universe of high yield and investment grade bonds to take advantage of structural inefficiencies created by rating agencies. More specifically, the strategy invests in European corporate bonds (excluding financials) which have, at time of purchase, a long-term rating between BBB+ and B– or equivalent by any other available rating agency such as Moodys and Fitch. The cornerstone of the strategy is to exploit credit spreads/valuation variations between the different rating buckets revealing the best risk/adjusted returns. The strategy follows a bottom-up approach which results in a conservative high conviction portfolio being built based on the credits’ solid fundamentals.
1Refinitiv, as of 30.09.2023
2ICE, Nordea Investment Funds S.A. Period under consideration: 31.12.2013–31.07.2023.
3ICE and Nordea Investment Funds S.A. As of September 2023