Fortune should favor the brave in European bonds


As the global stockpile of debt with negative yields has climbed to a record $17.4 trillion, it’s gotten very tempting to buy less creditworthy bonds to earn more income. With central banks still opening the monetary spigots and governments offering fiscal support to their economies, the risk/reward ratio in European debt looks likely to repay the more adventurous portfolio managers.

Yields are pretty low across the rating spectrum in European bonds. The average yield on debt with AA ratings, one level below the top tier, is negative. One rung lower, yields are barely positive. Investors have to stretch down to below investment grade to the BB category to earn more than 2%.

When yields spiked in March as it became clear the coronavirus would wreak havoc on the global economy, it turned out it was a great opportunity to load up on low-rated debt, which suffered a bigger hit than more creditworthy securities. The yield premium available from buying BB rated European debt rather than less-risky AA bonds soared to more than 600 basis points. That’s the highest spread since the global financial crisis more than a decade ago.

And fortune has favored the brave, with spreads on junk debt tightening ever since. 

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European junk debt’s current yield premium of about 220 basis points is in line with its five-year average and about double the low reached three years ago. That strikes me as surprisingly wide, given the amount of liquidity central banks have proven willing to pump into financial markets this year by purchasing both government and corporate debt and cutting interest rates. There seem to be few obstacles to a further tightening of BB spreads back toward the lows seen toward the end of 2017.

Unlike the Federal Reserve, the European Central Bank doesn’t currently buy junk bonds. But Gilles Moec, Axa Investment Managers’ chief economist, reckons it’s “plausible” that the ECB might allow companies that lose investment-grade status to remain eligible for its bond-buying program when it meets to recalibrate market support mechanisms next week.

There’s also a decent chance that such companies, known as fallen angels, will recover. A study published last month by the ECB showed that a quarter of the 659 borrowers that dropped into junk in the 20 years through 2019 subsequently mended their creditworthiness, becoming what are called rising stars.

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Sure, some of the zombie companies currently on the life-support provided by ultra-low interest rates won’t survive. Moody’s Investors Service expects the default rate among sub-investment grade borrowers in Europe to climb to 5.7% by the end of the first quarter of next year, a tripling from 2019’s rate. Transport, retail, auto and service companies are most at risk of not paying their debts after the pandemic crimped their earnings potential, the rating company said last month.

But as the chart above shows, on a historical basis the outlook is still relatively benign. Moreover, Moody’s is forecasting the default rate will drop back below 5% by August, with further declines in the following months.

Of course, there’s no extra reward without additional risk. The pandemic may continue to trash economic growth and company earnings in the months and years ahead, wiping out some companies. But for portfolio managers able to fish in lower-rated debt, the compensation available seems to justify what’s known as rolling down the credit curve.

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Bloomberg Opinion does not necessarily represent the views of AXA IM.

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