European Perspectives

Follow the ECB Compass

We expect forthcoming European Central Bank stimulus measures to be broadly supportive for European credit.

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In the midst of market volatility, macroeconomic uncertainty and geopolitical risks, we believe the European Central Bank’s (ECB) recent policy actions provide investors with a relative certainty: The ECB will remain accommodative. In turn, we believe European duration may be relatively well-anchored and European assets may be supported via the ECB’s expanded stimulus measures.

ECB tool kit
Short of large scale sovereign bond purchases, as we have seen in the U.S. and the UK, the ECB has taken a number of steps to date to ease liquidity conditions in the eurozone and assure investors of its continued pledge to do “whatever it takes”:

  • Forward expectations. The ECB is committed to keeping its policy rate “at present levels for an extended period of time in view of the current outlook for inflation”. (ECB, 7 August 2014)

  • Targeted longer-term refinancing operations (TLTRO). The ECB is providing European banks with up to €1 trillion in the form of four-year loans at 15 basis points (bps) via its TLTRO programme. Financing will be provided in eight quarterly tranches. We believe this will have several effects: It will add liquidity, reduce the supply of European banks’ short-dated bonds to the market and likely improve banks’ profitability by significantly reducing their cost of funding. The first tranche of €82.6 billion was provided in September this year, with the next tranche due to take place on 11 December 2014.

  • Asset purchase programmes. The ECB is committed to purchasing asset-backed securities (ABS) and covered bonds for “at least” the next two years as the central bank looks to expand its balance sheet by approximately €1 trillion to further ease financial conditions in the eurozone and support its goal to anchor inflation expectations. By removing ABS and covered bonds from the market in exchange for cash, the ECB is injecting further liquidity in the market in the hope that investors will use this cash to purchase other risk assets (ultimately lending to individuals and companies). This will support European ABS and covered bond markets, which have already tightened this year in anticipation of the ECB’s purchases. And it may percolate through to other risk assets via the portfolio channel effect described above.

We do not think the ECB will stop here: After all, its objective, often stated by ECB President Mario Draghi, is to “maintain inflation rates below but close to 2%”. And so far, the ECB is not meeting its objective. With current headline inflation in the eurozone running at close to 0%, Mr. Draghi is rightly concerned that if inflation runs too low for too long, the ECB risks de-anchoring long-term inflation expectations (see Figure 1).

The risk of de-anchoring long-term inflation expectations is that this could trigger – similar to what Japan experienced – a negative spiral of self-fulfilling prophecy: If individuals expect low inflation, if they believe their wages will not increase and prices will fall, they will delay consumption, slowing economic activity and, ultimately, depressing prices further into a deflationary spiral. Mr. Draghi has stated, “Should it become necessary to further address risks of too prolonged a period of low inflation, the Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate.” (ECB, 6 November 2014). However, policy rates are already near zero and Mr. Draghi has exhausted nearly all of the ECB’s tools, except one: a broad asset purchase programme, often known as quantitative easing.

More recently, Mr. Draghi indicated in his speech on 21 November 2014 that the ECB is already engaged in quantitative easing, and ready to do more ”without delay”. He stated, ”If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases”.

With that in mind, which asset class will be next on the ECB’s asset purchase list? Corporate bonds, European agencies, government bonds? Regardless of the specifics, additional asset purchases would be broadly supportive for European assets.

Sovereign bonds
We believe peripheral sovereign bonds remain an attractive carry trade, such as Italian 10-year government bonds at 2.02%, which are trading 130 bps wider than 10-year German Bunds at 0.7% (Bloomberg, 1 December 2014). Should the ECB commit to purchasing sovereign bonds, they could potentially provide attractive carry and further spread compression.

Improving financials
We also like financials. Since 2011, while corporates have been gradually releveraging from a very low base, banks are forced to deleverage as European regulators require ever higher capital ratios, better liquidity and lower total leverage. The ongoing de-risking and deleveraging trend is great news for bank creditors, and current market valuations present attractive opportunities to invest in this improving credit trend. We currently express our high conviction view in financials in two ways: For stronger banks, we invest in the subordinated part of the capital structure offering yields of around 4%–6% (see Figure 2), while for second tier banks, we invest in senior bonds. We find peripheral senior bank bonds particularly attractive at current yields (100 bps to 200 bps over Libor for three- to four-year maturities) given the ECB’s available four-year financing at 15 bps, which we expect will tighten peripheral bank credit spreads over the next 12 months.

High yield: supportive fundamentals
Finally, after four months of spread widening, global high yield is relatively attractive, with yields north of 6%. While we need to be very careful in an environment where eurozone growth is very weak, fundamentals are largely intact: There is very little high yield debt maturing over the next two to three years (see Figure 3). In the absence of a growth shock, default rates will remain low. With government yields (particularly in Europe) and default rates remaining low, investors will continue to search for carry; and high yield should remain well supported.

Within the high yield market, we favour higher-quality, BB-rated credits, secured first lien bonds as well as “rising stars” (credits that we expect will be upgraded to investment grade over the next one to two years).

We find a number of potential rising stars among financial services companies in the U.S., as well as in the North American energy sector, which is benefitting from the shale revolution and experiencing very fast growth, which allows for quick deleveraging and further investments.

In Europe, where the recovery is more fragile, we see a greater focus on industry consolidation. Positioning in potential acquisition targets may provide attractive total return opportunities, as we saw with GE’s acquisition of Alstom’s energy business, buildings material group Holcim’s acquisition of Lafarge and home appliance company Whirlpool’s acquisition of Indesit. We expect further consolidation to take place in the telecommunications sector going forward.

Conclusion
In a world of relatively low government yield, European (and global) credit markets offer some attractive opportunities for higher returns. Investors may favour flexible, diversified credit strategies, which can take advantage of market opportunities and deliver attractive return potential in the range of 4%–6%, with similar levels of volatility.

The Author

Eve Tournier

Head of European Credit Portfolio Management

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Convertible securities may be called before intended, which may have an adverse effect on investment objectives. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

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