Solid financials and attractive market valuations have led us to add to our long position in European investment-grade (IG) bonds, reallocating assets away from European sovereign bonds (‘neutral’; see table below). We have been building a position in European IG steadily this summer. Here are the four main reasons for our extended long.
From a fundamental perspective,
- company cash balances are high and rising
- interest cover is at historical highs (even at more challenged companies and sectors such as chemicals and cars)
- a spell of strong deleveraging is now behind us, leaving leverage surprisingly low.
Compared to earlier periods of stress (such as an impending recession or rising interest rates), this market segment now looks to be in better shape. In terms of valuations, there is a deep disconnect between market pricing – IG bond prices are at multi-year lows – and expected default levels, even in a worst-case scenario. As said, fundamentals such as cash balances and interest cover are strong, not justifying bond spreads at 2020 levels (see Exhibit 1) or a implied default rate of 9%. With credit spreads (and swap spreads) expected to narrow, we believe IG bonds in euros are now valued attractively versus equities.
Market technicals look favourable too: the turn from outflows to inflows in recent weeks may have ‘legs’. Further support should come from expectations that 12% of European BB+ (junk) rated bonds will be upgraded to IG over the next year, adding rising stars to the segment.
Finally, the current cycle should be different. As the economy slows down, high cash balances and low leverage can act as anti-stress buffers. Given that there is no apparent need to ‘repair’ cash or debt levels, there is no pressure on companies to engage in credit-denting deleveraging.
Asset class views as at end-August