European Investment Grade: Can the Rally Last?

David Stanley, Portfolio Manager, Fixed Income

Technical support for the region’s bonds may diminish soon

Government and central bank actions in response to the coronavirus have inserted some very positive technical drivers into the European credit market, compensating for deteriorating fundamentals. However, some of these technical drivers may soon diminish while fundamentals continue to decline, presenting a challenge for investors in European corporate bonds.

Technical factors have dominated European credit over the past six months as the region’s leaders have taken dramatic steps to counter the economic and financial fallout from the coronavirus pandemic. In March, the European Central Bank announced a €750 billion Pandemic Emergency Purchase Programme (PEPP), later expanded to €1.35 trillion, through which it is buying record amounts of debt to help European Union member countries cope with extra spending. The PEPP expanded on existing schemes including the asset purchase programme (APP) and the corporate sector purchase programme (CSPP).

The ECB has not been the only buyer of European corporate bonds. Following initial outflows when the pandemic first hit, there have been consistent inflows into investment grade corporate funds from investors encouraged by the central bank’s bond-buying programme and put off by the tiny spreads available in sovereign bonds and the possibility of defaults in high yield. Since PEPP was launched, bonds eligible for purchase under the scheme have outperformed ineligible bonds of similar quality and maturity: Euro-denominated European nonfinancial corporate bonds, which are eligible for purchase under PEPP, have delivered stronger returns than those domiciled outside the region, such as the UK and US, which are ineligible.

EU message of unity has boosted corporate bonds

Further support for the regional economy came in July when the European Union (EU) committed to raising €750 billion in capital markets to provide a coronavirus recovery fund for member countries. Some €390 billion will be distributed as grants, with the remaining €360 billion provided as loans, targeted at the countries most affected by the pandemic – the first time that some member states have benefited more than others from commonly borrowed funds. Although the primary impact of this stimulus has been economic, corporate bonds have additionally benefited from the message of unity given to highly-indebted sovereigns and the suppression of government bond volatility.

While this has been taking place, gross supply of European IG bonds has almost halted and net supply has turned negative. This marks a sharp turnaround from the initial wave of the market sell-off in March, when issuance spiked dramatically. Although supply typically slows in the summer before picking up in the autumn, US IG bond issuance has been much more robust.

The combination of surging demand and dwindling supply has helped the European IG bond sector to recover from the economic shock that obliterated markets in the spring. After selling off dramatically in early March, European IG spreads have recovered strongly, although they remain wider than pre-crisis levels. The asset class seems largely impervious to negative headlines, with spreads unaffected – so far – by reports that the global economic recovery may be stalling and that second waves of the virus are on their way.

Cash underperforms derivatives as investors seek liquidity

Another notable coronavirus-related technical development has been the underperformance, then recovery, of cash bonds versus credit default swaps (CDS). When the pandemic first hit and markets sold off indiscriminately, large numbers of companies were forced to issue bonds, some acting prudently, but others from a position of weakness to shore up liquidity. As they were issuing bonds in a rapidly declining market, firms had to offer significant concessions in order to sell them, accentuating the sharp spike in spreads.

The iTraxx Europe Index, which comprises the most liquid 125 CDS referencing European investment grade credits, was also highly volatile at the beginning of the pandemic. However, spreads on the iTraxx spiked much less than cash bond indexes as nervous investors preferred to trade in derivatives owing to their perceived greater liquidity. Before the pandemic struck, the average CDS-bond basis was only slightly negative (a negative basis means the CDS spread is smaller than the cash bond spread); this widened to -120 in March, in some sectors, making it relatively more attractive to go long credit risk in cash bonds. It has subsequently recovered closer to -30 basis points at the end of August.

Diminishing technicals could unleash volatility

Technical factors can have a very positive effect on corporate bond spreads and volatility, and can last for significant periods of time. However, fundamental issues cannot be ignored – and they have been deteriorating on average while spreads have continued to tighten. This has led valuations to become stretched relative to current economic conditions and the as yet moderate pick-up in corporate leverage. Valuations are more justified based on the 2021 outlook, assuming the economic recovery continues.

The medium-term outlook for the European economy is uncertain, however. If a major second wave of the coronavirus is avoided and there are no further national lockdowns, growth may pick up and bond spreads will likely remain stable; if, however, there is a major second wave of the pandemic resulting in lengthy national lockdowns, as opposed to current more regional lockdowns growth will likely slump again. Also of concern is what will happen government support schemes start to be relaxed, and whether this will trigger a surge in unemployment and an explosion of bankruptcies.  November’s US election is also on the horizon, bringing policy uncertainty and, potentially, volatility.

It is against this backdrop that any reduction in the technical drivers could lead to increased volatility and possible spread widening. The ECB has shown that it is ready, willing and able to support the Eurozone’s recovery. Corporate bond buying is not only set to continue, but there is scope for it to be increased if necessary. However, supply is likely to pick up again soon after slumping during the summer and become more in line with US issuance, reducing one of the key technical factors supporting European IG bonds

This does not imply that spreads on average are set to widen in the short term; it does, however, suggest that downside risks are growing, and that volatility could rise. If this occurs, corporate fundamentals are likely to come back into focus as investors seek to identify those companies with healthy balance sheets and strong cash flows that are well-placed survive further bouts of volatility and emerge stronger on the other side.


Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

EEA ex-UK—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.

Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.

UK—This material is issued and approved by T. Rowe Price International Ltd, 60 Queen Victoria Street, London, EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.

© 2020 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.

202009-1332322

Download

Latest Date Range
Audience for the document: Share Class: Language of the document:
Download Cancel

Download

Share Class: Language of the document:
Download Cancel
Sign in to manage subscriptions for products, insights and email updates.
Continue with sign in?
To complete sign in and be redirected to your registered country, please select continue. Select cancel to remain on the current site.
Continue Cancel
Once registered, you'll be able to start subscribing.

By clicking the Continue button, I acknowledge that I have read and accepted the Privacy Notice

Continue Back

Change Details

If you need to change your email address please contact us.
Subscriptions
OK
You are ready to start subscribing.
Get started by going to our products or insights section to follow what you're interested in.

Products Insights

GIPS® Information

T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

Other Literature

You have successfully subscribed.

Notify me by email when
regular data and commentary is available
exceptional commentary is available
new articles become available

Thank you for your continued interest