We have been saying for quite a while now that Investment Grade European corporate bonds are trading historical lows, in terms of yields, mainly on the back of the widely talked about 22 January QE announcement by the ECB, which QE program commenced in March but spurred a credit-wide rally since. Also in the US Investment Grade, yields are relatively low, not at historical lows as their European counterparts, partially a result of the build up to last month’s FOMC meeting/statement. But the question investors really want to know is; “where do credit markets go from here?”

Starting off with the US, we are of the opinion that the current yield differential between US and European bonds is not warranted (and should tighten further from this point forth), and, coupled with a stronger US dollar is expected to continue to drive demand for US credit.

This means that return potential in US high-yield credit is attractive, following the somewhat volatile period that was experienced in the build-up to the March FOMC meeting, which turned out to be more dovish than the market had previously anticipated.

Furthermore, as a result of a lower oil price, US credit and high-yield in general, bar those within the energy sector, are expected to remain better bid for the remainder of the quarter. Furthermore, with the Fed intent of delaying its first rate hike, US Treasuries got back in the fray and rallied sharply, bringing benchmark yields lower, and are expected to drag corporate bond yields lower too. 

Despite longer term concerns of rising interest rates in the US, US investors continue to pump money into US Bond Funds and Exchange Traded, with this asset class benefitting from ca $95bn worth of net subscriptions in the first three months of 2015, $15bn of which went into high yield bond funds. Nevertheless, we feel that any hike in interest rates in the US would be a gradual process and would not come in sharp abrupt moves, but rather a smooth and longer transition into higher interest rates, which could be considered to be a benign environment for the asset class, as the carry trade is sizeable enough to offset it.

In the Eurozone, credit markets continue to benefit from positive technical and are expected to enjoy more credit inflows, with yields expected to continue to trade lower on the back of another 17 months of €60bn worth of monthly asset purchases. With German Benchmark bunds already trading at or close to historical lows, there’s no stopping them trading lower (albeit Draghi’s ECB stated that purchases will only be done up to yields of negative 0.20%). This downward trend in benchmark bonds has made other European government bonds, most notably those in the periphery such as Italy, Spain and Portugal, but also Ireland and Malta, more attractive, and these sovereign bonds too are expected to benefit a positive technical backdrop.

However we must highlight one important factor, and that is the demand-supply dynamic in the European sovereign bond market. In its first two weeks of asset purchases, the QE successfully raked up the necessary bonds through purchases on the secondary markets, sending yields lower. In view of this, yields on, for example, Italian and Spanish government bond yields dropped, meaning that the cost of borrowing for these countries became cheaper, which encouraged them to lengthen their debt maturity profiles through the issuance of huge (billions) tranches of new bonds on the primary market.

This flurry of supply resulted in a retreat in bond prices (and an uptick in yields) towards the end of March as there was evidently a larger inventory of government bonds on the secondary market, removing the scarcity issues the ECB was being faced with earlier on in the month. However, supply should gradually fade and net supply is posed to decline as a number of bonds reach maturity later this year.

This article was issued by Mark Vella, 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.