European credit markets have performed well recently, all things considered. The question now is whether they’ve performed too well.
The ICE BofA Euro Corporate Index has returned a solid 3.2 per cent over the past three months. And for its high-yield counterpart? Make that 6.3 per cent. Not too bad for a region that only expects to avoid recession because of an unexpectedly warm winter and an Irish rescue (notwithstanding the rising rates and nearby war).
Fund managers are now evenly split about whether the “fast and furious corporate bond rally” has been warranted, according to Bank of America’s latest European credit-investor survey, out Monday.
On one side, 41 per cent of surveyed investors “say that the credit rally was justified by a mix of lower recession fears, cheap valuations, falling rates [volatility] and the return of inflows”, the bank writes.
On the other side are the investors — another 41 per cent of respondents — who “say that the credit rally has gotten ahead of itself, as rate hikes will hit the economy with a lag, and markets are too optimistic on the expectation of rate cuts.”
The bank’s strategists say the “pain trade” for now is even tighter spreads and even higher valuations. Fund managers are holding cash; this is partly because it now offers some yield, but also because of inflows from investors. The cash should provide some “dry powder” in a market where supply has been thin, they add.
But on a longer timeframe, “valuations risk becoming a stumbling block for the credit market as we head into Q2”.
One point of concern: the steepest credit rebounds have occurred in the real estate/property and utilities sectors, both highly sensitive to interest rates. Those gains signal at least some expectation of rate cuts, which were put on hold when the widely expected EU recession never materialised.
History isn’t working in credit investors’ favour, either: “credit rallies this big have only ever been seen on the back of ECB largesse,” the bank writes, whether through rate cuts or bond purchases. Yet as our colleagues Delphine Strauss and Colby Smith reported, ECB President Christine Lagarde has been striking a tone that makes even Fed Chair Jay Powell sound dovish.
This all provides interesting context to BofA’s breakdown of worries between investors in high-grade and junk-rated bonds:
It’s all a bit tough to read (despite the note’s above-average graphic design). But the poll shows that high-yield investors are most worried about a global recession, while investment-grade investors worry about a central-bank “policy mistake” (meaning a steep global recession caused by rate increases).
This is what you would expect. Junk-rated credit is more sensitive to growth and investment-grade bonds perform worse when interest rates rise.
But it also reminds us that if there’s really no energy-driven EU recession, the “policy error” recession becomes the more probable problem for markets. IG investors may want to take note.
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