Close Up: Taking Stock

May 7, 2024

Portfolio manager Ian Horn discusses the latest developments, themes and opportunities in the investment-grade market.

Credit spreads: Will Europe continue to outperform?

Investment-grade (IG) credit spreads in Europe have outperformed the US so far this year, as Figure 1 reveals.

In our view, this can continue based on strong corporate fundamentals, a continued spread premium versus the US, positive inflows to the asset class,¹  historically attractive yields and a greater likelihood of near-term rate cuts from the European Central Bank (ECB) than the US Federal Reserve (Fed).²

Rates: Will US rates continue to underperform?

US rates have materially underperformed since mid-March, as Figure 2 shows. This has been in reaction to changing expectations regarding the Fed and the ECB. The market now believes the ECB will cut before the Fed and continues to push back US rate cut expectations.

In early March, interest rate swap markets pointed to 4 cuts from the Fed in 2024, with the first in June. The same was expected from the ECB.

As of the start of May, swap markets point to 1, or 2 at most, cuts from the Fed this year, with the first in September or November. Following its May 1 meeting, the Federal Open Markets Committee pointed to a lack of progress toward its 2% inflation target as the reason for its caution.³

Meanwhile, the ECB is still expected to cut in June, with 3 cuts by year-end.⁴

Given persistent inflation in the US and the broad-based strength of its economy, we believe rate cut expectations are unlikely to be brought forward again. Potential new inflationary pressures could push them even further out.

Green and sustainable bonds: What’s behind the spread premium?

In Europe, the universe of green, social and sustainable bonds continues to grow.

This subset of the asset class subset now represents more than 16% of the European IG market by par-value outstanding, and more than 18% by number of issues.⁵  Almost one in five bonds now has some form of ESG angle, with issuance of green, social and sustainable bonds hitting US$281 billion in Q1, up 36% year-on-year and on pace to beat the record set in 2021.⁶

As highlighted in Figure 3, index data suggests ESG bonds - which for a long time traded tighter than the broader market due to strong demand and issuance from less cyclical sectors - are now trading at a spread premium to the broader European IG market.

We believe this has largely been driven by a greater proportion of ESG bonds being issued from higher yielding sectors such as real estate. Today, real estate represents more than 10% of the green, social and sustainable bond universe (up from 5% at the end of 2018), while representing just 5% of the broader European IG market. Meanwhile, the share of ESG bonds from the more defensive utilities sector has declined from more than 52% to 28% over the same period.⁷

Peripheral Europe: Is the spread premium justified?

Whilst risk premia have compressed in many parts of the market over the last 18 months, peripheral European corporates have continued to offer a premium over Western European issuers, as Figure 4 shows. This has increased since the middle of 2023, with peripheral European spreads lagging the recent spread rally.

"In our view, peripheral Europe continues to offer attractive opportunities, particularly where issuers have a global footprint, consistently show strong operating performance, or are more defensive."

Ian Horn

 

References

1.LSEG Lipper, ‘European Fund Industry Review, Q1 2024, as of April 29, 2024
2.Bloomberg, ‘Fed Rate-Cut Reluctance Will Limit ECB Leeway, Holzmann Says’, as of April 18, 2024
3.Federal Reserve, ‘FOMC statement’, as of May 1, 2024
4.Reuters, ‘ECB governors stick to plan for multiple rate cuts despite global headwinds’, as of April 22, 2024
5.ICE Index Platform, as of April 29, 2024
6.Moody’s Investors Service, as of May 2, 2024
7.ICE Index Platform, as of April 29, 2024

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of May 2024 and may change without notice.

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Index Descriptions

C0A0 - The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

ER00 – The ICE BofA ML Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.

ERGS - The ICE Euro Green, Social and Sustainable Bond Index tracks euro-denominated securities issued for green, social or sustainable purposes. Qualifying bonds must have a clearly designated use of proceeds that is outlined in the ICMA Green Bond Principals, ICMA Social Bond Principles or the ICMA Sustainability Bond Principles. Green, social and sustainable use of proceeds are segmented into individual indices.

EN00 - ICE BofA Euro Non-Financial Index tracks the performance of non-financial EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets.

ENCD - ICE BofA Euro Non-Periphery Non-Financial Index is a subset of ICE BofA Euro Non-Financial Index excluding all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

The Bloomberg USGG10YR Index tracks the generic United States government 10-year yield for the 10-year benchmark.

The Bloomberg GDBR10 Index tracks the generic German government bund 10-year yield for the 10-year benchmark.

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