Pendulum Swinging Toward Buyers in European Credit: Analysis

  • U.S. Federal Reserve policy seen a catalyst for repricing
  • Positive Treasury-bund correlation may trigger shift

Months of bargain-basement funding costs for European companies may draw to a close if the U.S. Federal Reserve has its way, Bloomberg strategist Simon Ballard writes.

Yield-starved investors have been at the mercy of bond issuers since early 2016 as they chased evaporating investment returns at ever tighter spread levels. But this dynamic could soon change as any sustained rise in U.S. yields will likely provoke a sympathetic response in Europe.

U.S. Treasury futures are pricing in more than two 25-basis points rate increases this year, after a flurry of statements by Fed officials recently stoked bets that they will tighten policy this month. The central bank’s so-called ”dot plots” imply three.

Any rise in yields in Europe will provide room for investors to be more discerning in both primary and secondary markets, with the latter potentially outperforming due to relatively lower liquidity and buy-and-hold characteristics of the segment.

Historically, German bunds have tended to move in tandem with U.S. counterparts. Since Donald Trump was elected president, Treasuries have underperformed bunds as investors positioned for the prospect of inflation and fiscal stimulus spending.

On the continent, yields have been anchored by the European Central Bank’s monetary policy and quantitative easing. But an upward bias could creep in if one assumes gradual normalization of the rates over the coming quarters as euro-zone inflation reached the ECB’s target of 2 percent in February.

Given this scenario, a tussle between borrowers and investors could ensue. On the one hand, corporate issuers will likely want to capitalize on current yield levels to lock in favorable financing before funding costs rise. But on the other, investors may hold out for more attractive investment opportunities.

In recent months, the depth of investor demand for spread product has meant issuers have benefited from almost ‘price maker’ status. Not only has the funding window been open to issuers across the credit curve, but more often than not lead managers have been able to meaningfully tighten the price of a deal between initial price talk (IPT) and the final terms. Such has been the recent depth of risk appetite that price discovery has on several occasions shaved as much as 35 basis points off the advertised spread.

Five-year funding costs for issuers of euro-denominated corporate bonds has fallen to 0.89 percent from 1.57 percent in January 2016, according to the Bloomberg Barclays Euro Corporate index.

Despite robust demand for new issues, one must be on the lookout for any signs of indigestion.

One sign of unease is the recent shift in European corporate spreads vis-a-vis U.S. equivalents. The European spread has only traded above the U.S. once in recent history, during the 2010-2012 sovereign debt crisis period.

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