Eurozone PMI data for August subsequently rose for a fifth month running, adding to evidence that the Eurozone recovery is gaining momentum. Importantly, the improvement is broad based with Germany rebounding strongly and periphery countries also registering significant improvement (but still not out of recession for the most part).
Improvement in economic conditions in Europe coupled with the Fed’s intention to start tapering its asset purchase program in the coming months has led to a fall in German government bonds prices, This has subsequently caused a re-pricing of euro corporate bonds.
While investment grade euro corporate bonds were offering a modest 1.75% yield to maturity back in May, the market has now corrected and today offers a more attractive income of nearer 2.30%.
I view this current level as fairly priced and offering a potentially interesting entry point for investors. While discussing the asset class with my colleagues this week, I highlighted the following points in favor of euro corporate bonds:
- I have a feeling that the negative pressure from a further correction in German bond yields may be limited going forward. The ECB is no Fed, and lack of inflation pressure will allow the ECB to maintain its easy monetary stance for the next 2 years. This is supportive for the short dated end of the market and should limit any further meaningful bond corrections.
- The improvement in economic conditions is translating into a better fundamental picture for European companies, which should start to be reflected in earnings. Moody’s expects the default rate in Europe to start declining by January 2014 which should help both euro investment grade and euro high yield bond spreads to decline.
- The bond performance of periphery countries like Spain, Italy and Ireland has been strong recently. As a result, it may make sense to rotate some sovereign periphery risk back into corporate bonds.
- European banks remain too large, and still need to reduce their balance sheets to meet Basel III rules. Consequently their debt issuance needs will remain low, and in fact they will likely continue to be net negative issuers of debt (i.e. issuing less than bonds maturing). This is a very supportive technical factor, in a sector that represents nearly half my universe.
The return of European growth can be to some extent a double-edged sword for corporate bonds investors. Historically companies have sought to take advantage of periods of very strong growth, by expanding via mergers and acquisitions (M&A), to the detriment of bond holders, as they have allowed leverage to rise.
However, we are currently only seeing signs of a gradual turnaround in Europe’s economy, and with unemployment remaining painfully high in many countries, this recovery will likely be modest and slow. In this environment, I therefore expect companies to remain conservative with a strong ability to service debt. From the perspective of the investment grade bond market, this growth is very much the ‘goldilocks’ scenario, not too hot, but not too cold either.
