22 AUG

2017

Fixed Income , Monthly Strategic Insight , Topics

Neutral exposure to expensive credit markets maintained

CORPORATE BOND STRATEGY

Neutral exposure to expensive credit markets maintained

Twelve-month earnings growth for Stoxx 600 corporates is up about 15% year-on-year without the base effect of Q2 2016. While earnings surprises for Q2 (68%) are slightly down from their Q1 high (71%), they are still above the average of 61% (based on 274 companies that have reported). On the US side, the domestic earnings season is weaker by about 2%.

Euro credit valuations continue to integrate fundamental improvements and appear expensive at these valuation levels, essentially on lower-rated bonds. However, technicals are well oriented and supported by strong Inflows. While the ECB will support this virtuous circle, IG cash spreads will be range-bound and capped on any correction. Financials remained our favourite sector, as they benefited from a better interest-rate environment and regulatory landscape, and a strong capital position, as demonstrated by Q2 results.

Favour European financial credit; cocos still the instrument of choice

We continue to overweight the financial sector (vs. the non-financial sector), which is benefiting from stronger fundamentals and relatively attractive valuations (though spreads, narrowing rapidly, are low). The financial sector is also supported by improving capital reserves (and asset quality), wider margins (on the back of rising interest rates) and the regulatory landscape. The banking resolution laws were put to the test recently as two banks (Banco Popular & Vincenza and Veneto Banca) were declared “failing or likely to fail”. In both cases, deposits and senior debt holders were protected as the losses were borne by subordinated debt and equity holders. While maintaining European financial stability is the main objective, we are still in a transitory period regarding the implementation of the Banking Resolution & Recovery Directive and, in some cases, like Italy, the political response may differ according to the interpretation of the law. Within the financial sector, our investment focus remains on cocos, which are benefiting from the earnings recovery, lower duration, and weaker correlation to US Treasuries. In terms of yield, these instruments match the levels presented by US high-yield credit.