Short-term headwinds for credit

CORPORATE BOND STRATEGY

Although most companies (77%) reported earnings results higher than anticipated by analysts, many revised to the downside their expectations for the quarters to come following increasing uncertainties regarding the global economic outlook, oil & commodity price drop and geopolitical risks.

For the credit markets, the main source of concern was, finally, the deteriorating health of some European banks triggered by ECB comments. In particular, in Italy, the sector came under intense pressure on the back of growing fears about the high levels of non-performing loans (NPLs). This has prompted the government to quicken negotiations on a guarantee scheme for banks’ NPLs with the European Commission. The achievement of such a structure is still uncertain, however. Further, many banks such as Deutsche Bank shook the markets on rumours that the German mastodon may struggle to honour coupon payments for its most junior debt (AT1).

All these elements have generated high volatility on the credit markets since the beginning of the year. Credit spreads are now at almost a 3-year high (Chart 4). The Oil & Gas and Miner sectors are the largest underperformers, given their high correlations to commodities. Finally, subordinated debt from Financials significantly detracted.

Still positive on financials

Longer-term, we still believe that, in a low-yield environment, with an accommodative monetary policy, a gradual recovery in Europe is generally a sweet spot for corporate bonds. But the current uncertainties are prompting us to a somewhat cautious stance. This cautiousness is reflected in our stance on non-financials. Nonetheless, we maintain a positive stance on financials. Despite the last correction phase, the fundamental ratios of financials are still in good shape, with an improvement in asset quality (Chart 5) due to regulatory guidelines. Technical indicators are also more unfavourable for non-financials, with a negative net supply, while the net supply is positive for subordinated debt, in line with regulatory developments.

Within the financial sector, we have a preference for subordinated debt (LT 2) compared to senior debt. The carry-to-risk is more attractive for LT2 in an environment where banking issuers are trading at lower levels than non-financial issuers.

Non-financials: neutral stance with strong differences between sectors

In the non-financial space, M&A activity has boomed during the last 2 years, downgrading the leverage ratio of companies. On the technical front, US issuers tapping the euro credit market should create a positive net supply in 2016 for non-financials. As a result, in the current environment, we judge it wiser to adopt a neutral stance on non-financial debt.

We are keeping our underweight on the Oil & Gas and on the Basic Resources sectors. Commodity prices have stabilised in a low range, putting sector profitability under pressure.

We prefer sectors less sensitive to the cycle such as Telecommunications and Utilities. The former has experienced a positive growth dynamic during the last 4 quarters, with solid margins (around 40%). The latest consolidation trend has also pushed the price up. The latter is less dependent on commodity-exposed assets (the EBITDA derived from those assets falling from 75% at the top to 45%). It also offers exposure to non-core, high-beta issuers still offering an attractive yield pick-up.