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Amid shifting market narratives on inflation, monetary policy and volatility, thoughtful positioning by sector, security and duration could be essential.
The euro investment grade credit index spread1 has tightened by about 100 basis points since the recent peak in October 2022, driven by increasing confidence in Europe’s ability to secure energy supplies heading into winter, the sharp drop in euro area inflation to just under 3% (YoY) as of year-end, and issuer credit fundamentals that remain relatively resilient.
That said, the index still offers what we consider a reasonable all-in corporate yield of 3.75%,2 which is near the high end of its range since 2010, and a spread of roughly 130 basis points, or just over a third of its all-in yield versus the 20% average in other developed IG credit markets.3
By sector, banking and real estate outperformed high-quality industrials in 2023 and into the first month of the new year.
We believe senior spreads for Europe’s “national champion” banks still have further room to compress to spreads on similarly rated, high-quality industrials, although the path may vary.
Banks continue to be the first “port of call” within credit for expressing views on market volatility.
We expect a more balanced impact for banks than industrials from the path of policy rates this year, as any future cuts could help bank spreads with yield-curve normalization providing greater comfort on future asset quality.
On the flipside, if central banks decide to keep policy tight for longer, we expect industrials (especially cyclical sectors), to see a more negative impact on earnings from ongoing weak economic growth.
Elsewhere, real estate spreads have outperformed other IG credit sectors over the past three months. Issuer fundamentals have held up, especially for logistics, residential and retail.
Market technicals have also been positive, with only €8bn of senior supply in 2023 compared to €83bn over the prior two years.4
That said, senior spreads for certain high-quality large-cap REITs are now somewhat compressed versus bank senior bonds and are trading near bank-secured funding rates.
Within the industrial sector, there remains relatively limited spread dispersion across highly rated large-cap issuers, although large-cap U.S. industrials in largely defensive sectors continue to offer more compelling value than core European industrials.
Stepping back, we believe that this could be another year of rapidly shifting market narratives on inflation, central bank policy and overall volatility.
Such an environment, in our view, could reinforce the benefits of thoughtful positioning by sector, security selection and credit duration.
Sources: (1) The average option-adjusted spread for the Bloomberg Euro-Aggregate Corporate Index. (2) As of February 5, 2024. (3) Market-cap-weighted average of index credit spreads to all-in corporate yield for U.S. dollar, sterling, and Canadian dollar corporate indices. (4) Source: Barclays.
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