Can euro credit withstand the expected macro turbulence?

  • 27 March 2024 (5 min read)
KEY POINTS
European Corporates may have some headwinds but are facing them from a strong starting point.
A selective approach to investment grade may be needed to access opportunities.
High yield offers attractive yields for portfolios however approach with caution.

Credit markets should continue to deliver attractive returns in 2024 with yields expected to close the year at similar levels to 2022. Nevertheless, it could be a bumpy road if recent macroeconomic data is anything to go on: the Europe consumer confidence index in February showed waning consumer confidence while the Eurozone flash PMI data was mixed. Alongside this, inflation data published in February showed a broad trend of disinflation, although core inflation is surprising on the upside.

While we see some challenges for corporates due to slowing consumer demand and margin pressures, they are benefitting from strong starting points. This is because companies took advantage of cheap financing conditions during the pandemic to strengthen their balance sheets. Consequently, although the level of cash on companies’ balance sheets has been ticking down, it is still 23% higher than before the pandemic with €480bn to offset higher working capital and capex requirements1 .

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Investment grade should continue to offer opportunities

Overall, we expect high-quality euro investment grade to remain well-supported. As long as European inflation continues to decrease and euro rates remain stable, we see certain sectors as offering interesting options for investors:

Financials currently offer an attractive risk-return ratio with a pick-up of 15bps vs. corporates for the senior bonds2 . We do not expect any positive surprises in terms of earnings for 2024 but rather a normalisation of trends from a strong starting position. Additionally, although there are indications that net interest margins for banks may decline slightly in 2024, they are expected to remain well supported and above historical averages. Of course, even across a sector we see value in, the devil is in the detail. The financial senior segment tightened by 4bps3  in February, but this hides a difference between German Banks and the rest of the sector; smaller German banks actually saw spreads widen.

Real estate is another sector that we see value in because of attractive valuations, relatively resilient valuations and higher rental income due to the housing shortage and indexation (offices, logistics, and retail).  Selectivity is key in this sector and we tend to find value in large and diversified structures that have access to the secured funding market.

Given the uncertainty of the outlook, defensive sectors such as utilities are also worth considering. Along with the potential to mitigate risk in a portfolio in case of an economic downturn, the sector offers attractive valuations notably in the primary market with visibility on earnings and cash-flow generation.

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High yield in an economic slow down

High-Yield issuers are well-positioned to handle a mild recession thanks to resilient earnings, lower debt and sufficient liquidity, although cost of funding is rising. Additionally, the fundamental strength of High-Yield is reinforced by issuers' ability to tap into both bonds and loan market under reasonably acceptable financial conditions. Consequently, although the default rate is expected to increase, it is projected to remain below the historical average.

We are finding some interesting opportunities based on attractive yields and a strong fundamental starting point, however we recommend a cautious and selective approach as macroeconomic headwinds persist. Currently, High-Yield has the potential to offer both income and total return potential to a portfolio, however idiosyncratic situations may create more dispersion. Weaker companies with lower margins and little room for error are likely to be the most vulnerable. Additionally, troubled issuers may struggle to access capital markets and refinance upcoming maturities, posing a risk in the High-Yield segment.

With economic data providing mixed views, diversification across euro credit should help investors mitigate the impact of potential volatility.  We believe taking a flexible approach to sector and country allocation as well as actively managing duration may help investors get the most out of euro credit opportunities in 2024 and beyond. 

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