HSBC's Steven Major Sounds a Bearish Alarm on European CreditBy
Treasury bull says investors no longer compensated for risks
Low volatility may give a false sense of security: Major
European investment-grade bonds will become a world of pain if volatility rises from record lows because investors aren’t being compensated for liquidity, default and downgrade risks.
On top of those dangers, high debt burdens and aggressive valuations will conspire to crimp capital gains on European bonds this late in the global credit cycle.
That’s the warning from U.S. Treasury bond bull Steven Major, who’s now sounding an alarm on credit markets in Europe. While Major, HSBC Holdings Plc’s head of fixed-income research, is a key proponent of the view that global interest rates can stay low for longer, he says investors aren’t being paid for the risks they are taking in corporate debt markets in the euro area, with yields a whisker away from post-crisis lows.
"Low volatility across asset classes may give a false sense of security and bond markets may be caught napping," HSBC strategists led by Major wrote in a note published Monday. "The risk is that with increasingly interconnected capital markets, driven by years of international spillover from quantitative easing, local triggers can have a more global impact than before."
Major’s bearish case: The European Central Bank’s asset-purchase program won’t be as large over the next year as the 12 months prior, while there’s a natural cap on credit demand as yields sit "materially below" typical expense ratios for retail funds, and to a lesser-extent insurance funds. "Gross yields leave very little left for income-seeking savers," he adds. "Spreads could widen with a volatility shock."
The strategist also takes exception with the argument that the euro-area economy is ensnared by Japanese-style stagnation, which would keep spreads in check for decades to come, amid low interest rates and a lifeless corporate sector.
The biggest reason the parallel fails: Japanese companies are awash with cash amid decades of deleveraging and low capital expenditures, with net debt at just 35 percent of gross domestic product. Non-financial corporate debt in the euro area, by contrast, has risen to 104 percent, from 92.5 percent pre crisis, suggesting investors should be better paid for the leverage sitting on Europe’s corporate balance sheets.
"Such expensive levels could persist for some time should volatility stay low, but this phase of the cycle is an unattractive time to own spread duration," Major concludes.
Even after currency hedging for euro-based investors, high-rated obligations issued by U.S. and U.K. companies with strong balance sheets still stand out as "less egregiously expensive investment choices for those market participants who still need to be invested at this stage of the cycle," Major says. HSBC also turned bearish on high-yield euro debt early last month, for the first time in three years, citing unattractive valuations.
When you adjust for the impact of credit ratings, investors in European high-grade debt are receiving even less compensation for credit risk, bringing premiums a fraction away from record lows.