Although faced with a changing set of challenges, investment grade credit markets today look more stable than they have since the onset of the global credit crisis in 2008.
In Europe, regional economies have pulled out of recession – albeit at a limp – and the sovereign debt crisis has been contained. Looking at the UK, the economic recovery has surprised to the upside, while the Bank of England (BoE) remains committed to ensuring a sustainable recovery. Although the BoE is the most likely of the occidental central banks to raise policy rates first, it has also indicated that the range of rates is likely to see lower peak-to-trough ranges than in previous economic cycles. At the same time, politics have again started to affect UK credit. Finally, the UK’s budget for 2014 has put forward proposals that have already started to cause considerable changes to the supply and demand dynamics for long-dated UK credit.
Finding value in sterling credit markets
Looking at investment grade credit, the effects of the global credit crisis are abating as evidenced by the decline in the rate of downgrades of investment-grade-rated companies (based on research by rating agency Moody’s), while the expectation of low default rates has been extended into 2014–2015. Market liquidity has improved (admittedly from a low base), with bid/offer spreads more consistent. According to BofA Merrill Lynch and EPFR Global, investment grade retail funds have seen steady inflows from investors in Europe in 2014.
More importantly, new issuance has not overwhelmed the supply/demand dynamics. Indeed, supply has fallen short of current investor demand. Given the less threatening background, we believe the sterling-denominated credit market, at a spread of 145 basis points versus swaps and a yield of 3.87% (BofA Merrill Lynch Sterling Corporate Index as of 1 May 2014), continues to offer the chance of both further spread compression and better total carry versus euro and global investment grade credit markets. Despite its smaller size, the sterling investment grade credit market offers a broad spread of credit issuers, with better spreads and yields than found in either the euro or US dollar markets (see Figure 1).
As we highlighted in our May 2011 Viewpoint, “Opportunities Still Abound in Sterling Credit Markets”, the broad sterling credit market, which includes more than 50% non-UK issuers, allows us to draw comparisons across the sterling, euro and US dollar investible universe of investment grade bonds. The sizes of the respective markets do leave the sterling market less liquid (i.e., it tends toward wider bid/offer spreads and less market depth). The BofA Merrill Lynch Sterling IG Corporate Index is currently £290 billion in size versus €1.4 trillion (equivalent to £1.7 trillion) for the Euro IG Corporate Index. Despite such size differences, we find that opportunities exist to buy attractive sterling-denominated issues that offer better relative spreads to euro- and US-dollar-denominated issues from the same borrowers.
Strong technicals benefit Europe’s credit markets
One of the key technical factors supporting investment grade credit markets since the onset of the global credit crisis has been the low level of net new issuance. According to Barclays and Dealogic, sterling markets and euro markets had net negative issuance in investment grade sterling credit from 2010–2012. In 2013, we saw a net positive issuance in sterling investment grade credit of some £12 billion; however, this falls short of the 12-year issuance average of £24 billion (according to Barclays as of 1 May 2014). This lack of issuance should continue to be supportive for spreads in European investment grade credit markets. A notable difference in sterling credit versus euro and US dollar is the percentage of European peripheral and emerging market credit issuances in each market-weighted index (see Figure 2).
We believe that sterling investment grade credit, with its mix of UK, European (core and periphery), US and emerging market names, offers investors a balanced credit market (see Figure 3).
Value and risk in the sterling investment grade market
We believe that sterling investment grade credit remains in a favourable part of its investment cycle, with ratings stable, leverage rising only moderately and spreads still wide compared to its long-term average. At PIMCO, we remain overweight to sterling investment grade credit, especially in light of some of the tighter spreads found in both euro and US dollar bonds from the same issuers.
We see opportunities
Financials remain a core overweight. New banking regulation and the European Central Bank’s (ECB) pending Asset Quality Review continue to drive banks to deleverage and become more stable institutions. We believe that, given the direction of regulation, senior debt trades too tight relative to subordinated bonds. As such, our overweight in financials remains best expressed via positioning along lower rungs of the capital structure versus underweights in senior debt.
During 2013, we saw a significant increase in the issuance of corporate hybrids (subordinated bonds issued by non-financial borrowers, which are callable after five to 10 years). To date, 2014 has seen a similar run-rate of issuance. We believe this sector offers investors the opportunity to invest in bonds issued by some of the most stable European issuers at notable pickups in spread to where the issuers’ respective senior bonds trade.
Finally, the ongoing recovery in the UK economy and Europe’s return to moderate growth leaves us supportive of exposure to cyclical sectors. In particular, we favour the return of the UK consumer, with overweight in both the real estate and retail sectors. We also have some overweight in the building materials and metals and mining sectors. However, given only moderate growth in emerging markets, this view is focused on select names, rather than broadly across sectors.
The changes to the annuity market announced by the UK’s Chancellor of Exchequer George Osborne in April this year have resulted in a change in the shape of UK credit curves. Historically, sterling credit curves have been flatter than US dollar markets.
In sterling credit, longer-dated bonds have a similar spread over their respective government bonds to medium-dated bonds, whereas in US markets, spreads of longer-dated bonds trade at wider spreads than medium-dated bonds from the same issuer. We believe this will change as the demand from annuity funds for longer-dated bonds will decline. Already, we have seen some evidence of this change (see Figure 4).
As we mentioned earlier, the rise of political influence on companies’ profits is very much back in vogue in the UK. For example, the debate on what UK electricity and gas companies can charge their customers has become highly charged, and is likely to last up to, and beyond, the next UK election in May 2015. This creates heightened uncertainty on cash flows, may affect the appetite for increased capital expenditures and could affect profitability. Added to this uncertainty is a separate review on what water supply companies can assume on their weighted-average cost of capital (WACC). Put together, we are left wary of this sector and remain underweight many UK-based utility names.
The return of merger and acquisition (M&A) activities in Europe has become a feature of 2014, notably in two sectors – telecoms and pharmaceuticals. While we do not believe that this is the start of a rapid rise in leverage in European and UK companies, M&A activity, which has been almost dormant since the crisis began, has returned. The ease with which companies can raise financing was demonstrated by a recent €16 billion multiple-debt issue from a high yield issuer (post-M&A). It highlighted the market’s capability to absorb a large supply of credit without any notable effect on secondary bond spreads. The return of M&A activity leaves us wary of much of the telecom sector, where valuations are only fair in most names and event risk is rising.
We believe that investment grade and crossover (near-investment-grade) credit markets are in a favourable part of their respective cycles. Looking ahead, we expect to see better growth in the UK, but not enough to trigger a rapid rise in rates from the BoE. Across Europe, moderate growth prospects are returning, which in turn will help the UK economy. European corporates remain mindful of their leverage ratios and will not likely rush into shareholder-friendly activity.
At current levels, credit spreads in the sterling investment grade credit market and select high yield names continue to offer potential for tightening versus the euro and the US dollar markets, where spreads look closer to fair. In light of the ECB’s latest round of policy action on 5 June 2014, we believe that investment grade credit is likely to remain a key component of asset allocation over the secular horizon.