April 2015 - Credit - When credit spreads trade higher than yields

The first half of April saw a continuation of the bullish risk-on trades of March in most European asset classes. However, after reaching an all-time low at 0.07% during the month, the sudden volatility in the 10-year German government bond – alongside the rest of its curve and other Eurozone government bonds – and its return to a 0.37% yield at month-end contributed to a nervous end to the month for investors. Such nervousness was all the more justified as some were expecting the newly-launched ECB’s QE program to starve some government bond investors to the extent that the entire curve would turn negative for core European sovereigns. In the big scheme of things, the recent back-up in risk-free yields is still limited and most European govies remain close to historical lows. But it validates our conviction that there will still be ebbs and flows in the markets during the 19-month minimum length of the ECB’s QE program.

In our view, the same trend applies to European credit markets. On the bullish side, some European HY cash credit indexes traded at spreads higher than their underlying yields for the first time ever during the month and Switzerland-based consumer goods manufacturer Nestlé – regarded by many as the Rolls Royce of European corporate credits – recently issued bonds at negative reoffer yields. On the cautious side however, we argue that such valuation levels leave IG long-only investors in a vulnerable situation at a time when many IG issuers will likely consider increasing leverage and implementing credit-unfriendly actions, when IG credit spreads are close to historical tights, and when the total returns of the IG market segment will be so correlated to those of Eurozone govies. As a result, we currently err on the cautious side in IG and are planning to increase our short positioning by adding some new single-name situations which are prone to increased event risk in the next few months.

Interestingly for corporate HY, this current backdrop supports the acceleration of some of our catalyst-driven positions with the growing pace of refinancings, stock market IPOs and M&A activity. Furthermore, it may also support the emergence of potentially attractive new post-restructuring debt situations which had been in limbo for some time. The debt-for-equity exchanges currently implemented at Netherlands-based waste management group VGG and at France-based aerospace equipment manufacturer Latécoère are cases in point and may eventually become attractive positions on the long side for the Fund once the dust settles. In the meantime, the closing of M&A transactions for our Poland-based and Spain-based media groups, and the expected capital raising by our UK-based car manufacturer and our France-based car rental company also highlight that many stories may continue to play out in a favorable manner in the current environment.

Beyond the traditional ebbs and flows of financial markets which the ECB QE program will not eliminate, our judgment remains that European credit – in particular B and CCC corporates, as well as bank hybrid capital instruments – may well end up being the asset class to benefit most from the current outlook for credit fundamentals, markets technicals and investor positioning.