The steady drop in European sovereign markets made the headlines this year as the anticipated Japanification of the European credit took hold of the markets.
Specifically, the mix of persisting deflationary fears and the aggressive bond-buying programme announced by ECB pushed the yield for the 10 year German bond to circa 0.35% from 0.5% at the beginning of the year with the retreat in yields extending across Eurozone credit.
Against this backdrop, the yield for the Investment Grade Euro bonds fell to 0.64 per cent from 0.8 per cent in December 14, resulting in a year-to-date return of 1.8 per cent.
However, this reflects to a large degree the trend in government yields as the spreads to these improved only marginally so far this year. On the premise that the euro market is undergoing a Japanification process, spreads should tighten over the coming months and experience a flattening across maturities.
As low as the current spreads might seem (0.5 per cent over the German yields), they are more than double the ones prevailing in Japan or the ones seen pre-2008 in Europe (where the average for 2000-07 was 0.19 per cent).
Meanwhile, in my opinion, there appears to be limited scope for a reversal of the bund’s gains as the strong ECB bond buying programme and the tight deficit targets set by Europe’s core economy will put upward pressure on prices.
In the same vein should act the delayed recovery in long term inflation expectations which continue to remain at unhealthy low levels. The longer term corporate investment grade bonds should thus be set for continuous out performance over the upcoming months.
The perpetual notes, better known as corporate hybrids given that they were designed to exhibit a blend of debt and equity specific risks to enhance/support credit ratings, are likely to continue delivering steady returns. Indeed, given the sizable yield pick-up that such bonds offer they have been experiencing an aggressive spread tightening (six per cent year-to-date) and a strong 2.77 per cent total return so far in 2015.
Moving on to the USD bond market, the investment grade credit delivered a 2.2 per cent total return year-to-date mainly on account of the fall in US government yields which were brought down by the ongoing fall in yields elsewhere, speculations that the interest rate hiking will be delayed and by the prospect of an appreciating dollar.
Meanwhile, the spreads continued to widen as did the gap between the EUR and USD investment grade spreads which now reached 0.95 per cent. While the letter reflects in part divergences in maturity, fundamentals, growth cycle and supply, one would expect the spreads here to look increasingly attractive relative to the ones in the Euro space and gradually lure in investors. Such evidence is gradually emerging as dedicated US retail funds have experienced non-trivial inflows lately.
After a dismal year ending, the high yield market total returns moved into the positive territory, with spreads tightening in Europe and remaining almost unchanged in the US where the continuous weakening in energy names took a toll on the market.
Of note, the EUR single-B rated bonds outperformed the higher rated high yield notes, a trend which is easy to explain if one considers that in late-2014 the spread ratio between the two classes reached crisis-like levels; indeed, barring a sharp contraction in the European economy, this spread compression trend should gradually gather pace as the year progresses.
A similar movement should unwind in the US market as well, particularly as here the economy is on a stronger foot and the contagion from investors’ uneasiness around the market’s exposure to energy names appears to gradually fade.
After all, the BoAML US high yield index carries a yield of 6.3 per cent, whereas the EUR index yields four per cent; the difference is largely attributable to the difference in duration but in a world where the search for yield becomes more cumbersome, yields look set to remain low for lower and European growth outlook remains subdued, this might be of lower concern.
To add to this argument, for the past two weeks Lipper reported a strong pickup in US retail high yield funds net inflows (with the year-to-date total now reaching $4.97 billion).
Disclaimer:
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.