This time last year, European credit markets were strongly recovering from what can be described as a sharp (and let’s face it, a much welcomed) correction in corporate bond prices, both in the investment grade and high yield space, and in the summer months investors and asset managers alike were wondering whether the market was ahead of itself in terms of valuations and if the summer lull would provide some relief in terms of pricing.

In all fairness, there have been some short bouts of weakness since then, particularly in November 2017, but week on week, month on month, quarter on quarter – credit has marched along. And many a time, along the way, we’ve looked back wondering how that was possible. How, given the seemingly expensive valuations in terms of tight spreads, could credit continue to grind tighter? This, notwithstanding the increase in net supply of bonds, particularly in the eurozone, given the historically low yield environment we have been experiencing of late.

Well, the answer is pretty simple. Credit has historically been the asset class which provided investors with limited volatility – yet returns commensurate with the volatility. And this preference for the asset class has kept prices supported. Quantitative Easing has also played a significant part in keeping spreads tight and bond prices supported. In addition, the effects of QE are now being felt, albeit slowly and in a delayed manner, in the wider economy in the eurozone.

Companies boast healthier balance sheets, cash flows have improved, the economic conditions in which they approved have a more favourable outlook and consumer confidence is more upbeat than it has been in the past three years. To top it up, the lower yield scenario has provided bond issuers with the optimal opportunity to refinance bonds at lower yields and lower coupons, and hence lower overall financing costs while extending their bond maturity profiles in the process.

So to say that, following the run we have had so far, downside pricing risks will persist even further would not be a new phenomenon. What is a novelty to the European high yield bond market is the fact that the bonds issued over the past 12 months have been issued at significantly lower coupons. The carry trade of the European high yield bond market has been squeezed significantly, and has not yet been put to the test. The point here is that, when markets corrected and spreads widened, the previously higher coupon used to serve as a buffer and limited to some extent a correction in bond prices.

This time round, when the correction eventually comes, it could be more abrupt. Price movements can be sharper as the low coupons will further accentuate the price returns. This should be kept in mind, both when viewing bonds on a standalone basis but even more importantly within the context of a bond portfolio. And that in my opinion is one of the greatest challenges to be faced with over the coming months.

Disclaimer:

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. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.