Opportunities in European Investment-Grade Debt

Jan 19, 2023

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The repricing of financial markets in 2022 led to short-term pain for fixed-income investors. However, with most of the selloff now potentially in the rear-view mirror, a reallocation back into bond markets is approaching as rates begin to peak. European investment-grade credit spreads in particular are starting to look attractive in the medium term, as new opportunities emerge from recent volatility and the sector’s increased credit dispersion.

The European IG market, like the broader credit market, is surrounded by uncertainty after a volatile year. Heightened geopolitical risks remain in place, as does persistent inflation. Europe continues to grapple with energy shocks that have limited progress in reducing supply-chain disruptions, creating stickier inflation. Slowing growth around the globe is thus forecast to be more pronounced in Europe. Stagflation appears to be the most likely scenario, with risks currently skewed toward weak growth coupled with elevated inflation. This raises the odds that rates will be higher for longer.

Yet spreads already reflect much of the perceived downside risk, and European corporates are showing signs of underlying strength. During previous market cycles, spreads have not spent much time at levels similar to today’s before mean reverting and tightening. The European market’s underperformance versus the US has left spreads in the former generally trading at more attractive levels. As volatility persists, the relative-value opportunities among European corporates are broadening.

Credit fundamentals are starting from a position of strength, giving European corporates some breathing room should inflation continue to rise and squeeze margins. Profit margins have widened, share buybacks remain subdued, and leverage ratios are recovering as EBITDA growth improves on a year-over-year basis, underpinned by the lifting of COVID-19 lockdowns in Europe. Looking at the global macroeconomic landscape, China’s decision to scale back its lockdowns could offer a boost to European trade and the region’s industrial sector. Final data for 2022 will likely show that full-year growth was solid, reflecting base effects and strong momentum in the first half of the year as economies reopened.

As volatility persists, the relative-value opportunities among European corporates are broadening.

The outlook for 2023 is murkier, as global growth weakens and the ongoing Russia-Ukraine war contributes to higher commodity prices. As a result of Russia’s invasion and its impact on manufacturing supply, the eurozone finds itself in a much tougher position than the US. Goods inflation in Europe is unlikely to cool and revert to more normal levels as soon as in the US, taking into consideration the state of supply chains in Europe and the impact of the energy crisis on the factory sector. Unemployment rates are historically very low but are forecast to worsen as the economy weakens.

Then there’s the European Central Bank. The central bank’s posture proved to be more hawkish than investors were anticipating in December, even as officials raised interest rates by an expected 50 basis points. ECB President Christine Lagarde sent a clear message to the market that more policy tightening is coming, including additional rate increases, despite the property sector already sending distress signals. Echoing messages from the Federal Reserve, the ECB has signaled that rates will ultimately need to rise to a higher level than investors had expected and remain restrictive for some time to bring inflation under control.

Investors should prepare for volatility as the winter gas crisis and the timing of the ECB’s rate moves come into focus. The war in Ukraine, the energy crunch and the potential for new shocks mean that macro risks will remain elevated.

While investors no doubt face a tepid growth outlook in 2023 with earnings growth stalling, this environment is supportive of credit. We are nearing multi-generational highs in inflation and yields. Wherever rates peak, it will likely set the high-water mark for years—perhaps decades—to come. Globally, IG yields have already reached levels not seen in more than a decade.

Rating and Maturity Adjusted OAS Investment-Grade Index

As of September 30, 2022. Source: ICE BofAML, PGIM Fixed Income and ICE Data Indices, LLC, used with permission. An investment cannot be made directly in an index.

While spreads for European high-yield debt and US corporates are still vulnerable in the short term, European corporate spreads have widened materially from tightened pre-pandemic levels, notably for IG. Spreads in European IG have recently moved closer to the wider levels seen early in the pandemic, a trend that emerged as spreads rallied in the fourth quarter of 2022, outperforming US IG.

Examining individual credits within the European IG sector, increased credit dispersion enhances the set of single-name alpha opportunities. We prefer financials, particularly banking, to compress into corporates, and utilities over lower beta industrials. We also see value in corporate hybrids, as well as select strong BBBs and non-CSPP eligible paper.

EUR IG Credit Spreads Not Far From the COVID-19 Wides: Euro OAS Financials vs. Non-Financials

As of September 30, 2022. Source: Bloomberg. Past performance is not a guarantee or a reliable indicator of future results. You cannot invest directly in an index.

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