European credit market: preference for non-financials versus financials

Year-to-date, the $ credit markets have outperformed the € markets, with $HY posting 11.60%, $IG 10.4%, €IG 6.4% and €HY 4.4%. In terms of subordination, senior corporates continue to outperform subordinated debt, while contingent capital bank instruments remain in negative territory. Regarding  sectors, basic resources, along with energy and real estate, are among the top performers. In terms of asset allocation, we have a preference for US credit over European credit. While the ECB will certainly support growth with additional easing measures and thus limit the downside risk, Brexit will shift the focus to a better macro environment, as in the US. Moreover, European banks are still under the spotlight, with UK commercial real estate exposure, the Italian non-performing loans problem and the publication of the European Bank Authority stress tests at the end of July. In this context, the US credit market appears as the new safe-haven investment in a very low-yield environment.

European credit market: preference for non-financials versus financials

On the €IG, we observe a decreasing correlation between Financials & Non-financials. Since the announcement of the CSPP, eligible bond risk premiums have tightened by 30% (non-eligible bonds only by 10%). They are the main beneficiary of the ECB‘s CSPP programme, which is on track for an €8-10 Bn monthly run-rate. The recent slowing in the primary market linked to UK uncertainties and the quarterly results blackout are supporting the technical backdrop. The ECB, however, is emphasizing the supply scarcity and the illiquidity of the asset class, and this is pushing investors to rotate to better-yielding asset classes like High Yield. The latter is benefiting from lower duration, a higher risk premium, a still-low European default rate (major bankruptcies are confined to the US metals & mining and oil & gas industries), eased credit market conditions and strong technical factors as demand outpaces supply.

Following the Brexit, the European banking sector largely underperformed. All eyes were on the housing market and particularly on the commercial real estate market, which is typically riskier than the residential. Lending on UK Commercial real estate amounts to £160 bn while £69 bn only are on the UK major domestic bank balance sheets. This represents 6% of the total loans of 4 domestic banks and does not constitute a systemic risk to the UK financial sector.

The big problem is that of the Italian banking sector, in the light of its non-performing loans (NPL) level. NPLs represent 17% of the total loans, i.e., €350bn, which is equal to  20% of Italian GDP! By comparison, the European average stands at 4.3%. Although the NPL’s new formation is declining, the ECB has pressured Italian banks to rapidly lower their current stock. It has asked Monte to shed €10 Bn of net NPLs by the end of 2018 as a first sign towards a real solution! Moreover, the EBA stress test results, due for publication on July 29th, will again point to the weakness of the Italian banking sector. Intesa Sanpaolo should be one of the more resilient and Banca Monte Dei Paschi the bad pupil. Several possibilities are available but the most practicable would be a recapitalization of €25-30 bn for the whole sector. For all these reasons, we are keeping a negative view on the Italian banking sector and avoiding subordinated debt.

Us credit market: the new safe haven in a low-yield environment

In the US market, we prefer the HY to the IG segment.

US Investment grade market is less exposed to the Brexit and offers an additional yield of 2% vs. the European market. US credit offers the highest yield in the fixed-income landscape, where 48% of the European market posted a yield below 0%. High Yield benefits from the chase for yield and a still-benign default rate, with no sign of contagion emerging from sectors other than energy & mining. 

Covered & Convertible bond landscape

Despite a surge of 56% in Q1 2016, net supply in the covered bond market is still negative. Moreover, currently, 74% of covered bonds are carrying negative yields. As a result, there is no more value in the European market, due to the ECB’s APP.

On the convertible bond market, there are some opportunities to catch the equity momentum. Technicals are positive and the global convertible market continues to shrink. The net supply is clearly negative, which strongly supports valuations.