Company Bonds in Europe Surge as Slow Growth Spurs Rate-Cut Bets

Investors are demanding record-low yields to hold investment grade bonds in Europe amid speculation benchmark borrowing costs will be cut to counter slowing growth.

Spain’s Banco Santander SA and Italian lender UniCredit SpA have led a rally which has seen yields falling to 1.86 percent, Bank of America Merrill Lynch’s Euro Corporate Index shows. The cost of insuring against losses on company debt fell for a third day, with the Markit iTraxx Europe index of credit-default swaps linked to 125 investment grade companies dropping three basis points to 108, the lowest in more than a month.

Services and manufacturing shrank in the euro area for a 15th month in April, a report showed today, boosting speculation the European Central Bank will cut interest rates to spur growth. Confidence in corporate bonds from the region’s most indebted countries was lifted as Spain’s recession eased in the first quarter and Italian voters re-elected President Giorgio Napolitano, who pledged to break the country’s political deadlock.

“The market is craving good news and Napolitano’s re-election is a step in the right direction,” said Juan Esteban Valencia, a strategist at Societe Generale SA in Paris. “There’s a lot of cash looking for a home in a market distorted by the central bank. Peripherals and lower-rated companies have tightened the most.”

Government Debt

Euribor futures gained in the past week, showing that investors are boosting bets the ECB will lower its benchmark interest rate. The implied yield on the contract due in June slipped to 18.5 basis points, the least since March 6.

Yields on non-financial company bonds from Europe’s peripheral nations fell to a record 2.5 percent, Bank of America data show. The move mirrored declines in Spanish and Italian government debt. Italy’s 10-year notes dropped below 4 percent for the first time in almost 2 1/2 years, while borrowing costs for Spain and Portugal declined to the least since 2010.

Average yields on bonds of Banco Santander, Spain’s biggest bank, dropped 67 basis points this month to 2.6 percent, while yields on UniCredit fell 63 basis points to 3.8 percent.

The premium investors demand to hold European corporate bonds instead of benchmark government debt is holding at 132 basis points, the lowest since January 2008, Bank of America Merrill Lynch data show. The spread for peripheral corporate bonds narrowed to 192 basis points, approaching a 19-month low of 182 basis points reached Jan. 11.

Risk Exposure

Investors challenged by record-low interest rates may “accept greater risk exposure in order to generate a higher potential return”, Michael Krautzberger, head of European fixed income at BlackRock Inc. wrote in a report today. That approach “prompts us to ask whether current monetary policy may be encouraging investors to pursue inappropriate risk strategies in their search for higher yields.”

Investors seeking more risk are favoring corporate bonds rated BBB, driving yields on the notes down four basis points yesterday to a record 2.5 percent, according to Bank of America Merrill Lynch data. That compares to an average yield of 1.1 percent for AAA rated securities, 25 basis points above the record low of 0.89 percent reached Dec. 10, the data shows.

Investors poured $871 million into high-grade bond portfolios in the week ending April 17 while pulling $825 million from equity funds, according a Bank of America report.

“There have been lots of flows into credit from equities and government bonds,” said Valencia. “Today we have record-low yields, but in a week’s time and a month’s time they’ll be even lower.”

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