Mary Pieterse-Bloem

Global Head Fixed Income

The sun will shine on credits again

4 June 2020 - Central bank policy measures, taken in response to the coronavirus, have decimated core government bond yields. In the strong risk-off reaction we have seen recently in markets, credit spreads also widened considerably. The latter currently present an opportunity for investors, especially those bonds that are part of the open-ended quantitative easing programme of the ECB.
The corona pandemic has dramatically changed the fixed income landscape too. Central banks were first to respond. The combination of their policy measures and a quickly deteriorating economic outlook led to a sudden drop in long-dated core yields (yields on government bonds such as US Treasuries and German Bunds). When national governments subsequently announced their massive rescue packages, bond holders looked in awe at a growing mountain of debt. Core bond yields were briefly subject to a tug of war between these two forces: an increase in bond supply due to government stimulus measures versus higher demand due to central bank asset purchases. Central banks won the battle. “Don’t fight the Fed”, as bond traders often say. The same is true for the ECB, and we agree. We expect core yields to stay very low, well into the economic recovery from the coronavirus. This means that core bond yields will provide even less protection than previously from an unexpected economic downturn (resulting, for example, from a second corona wave).

Corporate bonds are attractive

European investment-grade corporate bonds present a better opportunity. While on average the credit spread on these bonds has been 150 basis points over the last ten years, it is currently around 200 basis points (IG Corporate Bond Index option-adjusted spread versus German Bunds). That is an extra 2% yield for bonds that are being bought by the ECB. Strong corporates were issuing recently, but we expect this supply to dry up soon. The ECB can then no longer fill its needs through the primary market alone, but will also have to buy these corporate bonds in the secondary market. This, and the economic recovery that will come in sight, will lead to lower credit spreads. Even if our more negative economic scenario unfolds, will these credit spreads not widen so dramatically again due to the protection that these bonds are enjoying from the ECB. It is also conceivable in that scenario that the ECB will incorporate the bonds that are downgraded to speculative-grade (high yield) in its asset purchase programme, just like the Fed has done in the US.

Cautiously optimistic on peripheral eurozone bonds

Eurozone peripheral bond spreads, which also widened considerably, present an interesting opportunity for the same reason. The ECB is clearly doing everything within its might to contain the yields of those bonds (bond-buying programmes play an important role in yield suppression and since prices move up when yields go down, this is favourable for bond holders). It will continue to do so, undeterred by the ruling of the German High Court (challenging legal aspects of ECB asset purchases) and other ramblings. Although we consider these bonds an attractive opportunity in the long run, there is a fair chance that they remain under pressure in the short term, due to negative credit rating action and because the political situation is quite fragile in both Italy and Spain. We prefer Spain over Italy at present.

High yield and EMD remain tricky

Current spreads on high yield and emerging market debt (EMD) are very attractive if the way out of the corona crisis is a straight line up. Chances are, however, that this will not happen, in which case these spreads can widen by several hundreds of basis points again. Although we are confident that in the long run high yield and EMD spreads will be below their current levels, these bonds are currently only for those investors that can stomach their volatility.

Mary Pieterse-Bloem - Global Head Fixed Income