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Flash Note

The Credit Outlook

16.03.2017

Our unconstrained approach allows us to seize strong opportunities, as we did recently in the financial, commodity and structured credit spaces

Outlook

If European core inflation rebounds faster and more sustainably than expected by the consensus, market anxiety about a possible faster conclusion to ECB asset purchases requires a cautious allocation to corporate credit. In addition to more than two years of negative deposit rates, European investors have faced an ever shrinking bond universe as the ECB has materially expanded its balance sheet over the last five years. This narrower universe of opportunities has forced investors to take greater credit risk and at longer maturities, leaving credit markets very vulnerable to a shift in ECB policy.

Starting with investment grade corporate bonds, we can see a steady deterioration of balance sheet quality to near cycle-high leverage ratios. Weak margins, lack of investors discipline, a still strong M&A cycle, and active bond issuance to capitalize on low rates have all worked to undermine European balance sheets. Despite reaching 10 year highs in leverage, yields are at all-time lows because of the intervention of the ECB just discussed. This market is very fragile and vulnerable to a strong spike in inflation.

In high yield bonds, the story is similar with cycle-high leverage ratios combined with all-time low yields. In addition, not only is there no absolute valuation protection in these low yields for such poor balance sheet quality, but also no relative valuation protection looking elsewhere in the capital structure. For the first time in history, the European high yield bond index is yielding less than the European equity index (dividend yield for the Eurostoxx 50 index) as shown in the graph below.

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Opportunities still persist

Since the summer of 2012, we have benefited from an outsized exposure to European banks across the capital structure. The top down drivers to this theme remain in place: European banks are one of the few sectors in all of global credit with a multiple-year visibility of continued de-leveraging. Regulatory changes have driven 7 years of deleveraging and de-risking that is likely to continue through 2019. In particular, we think subordinated bank bonds are particularly cheap in absolute terms, but also relative to industrial high yield. Indeed, spread premium for a European coco index versus industrial high yield is more than +150 basis points. These contingent convertible bonds are subordinated bank capital instruments, and carry specific coupon and capital event triggers in case of very large losses. But in our view, because this asset class is young, isn’t included in broad market indices, and because these instruments haven’t been properly tested, the underlying credit risk is mis-priced. Quality retail franchises such as BBVA or Unicredit, especially if issued during times of heightened political uncertainty, can be purchased for very attractive 8-9% yields.

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Besides, we still like European Collateralised Loan Obligations. This remains a broken asset class, where regulatory constraints and crisis scars allow us to benefit from very attractive spread levels. Furthermore, the default rate on European CLOs has been very low over the past 20 years.(1) While we first focused on AAA tranches, we currently adopt a more tactical approach to seize opportunities in more junior segments. AAA spreads are now close to their post-crisis tights. On the other hand, junior spreads are still at wide levels and offer very attractive risk/adjusted returns (spreads are at around 600 basis points for BB tranches and at 800 bps for B tranches) for similar technical reasons: the investor base has not really expanded to absorb new issuances resulting in a stabilisation/widening in credit spreads.

Last but not least, commodity related corporate bonds remain attractive as they should benefit from the pick-up in global growth and inflation and from commodity price rebound as well. However, selectivity is key in an environment that will remain volatile. Evaluating each country and corporate risks and opportunity set is fundamental to singling out the best stories in this asset class.

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