Cracks Appear in Europe’s Credit Rally

Jørgen Kjærsgaard

We’ve seen some dramatic price moves in the riskier European bonds since 26 July, when European Central Bank (ECB) president Mario Draghi assured the markets that “whatever it takes” would be done to save the euro.

Investors, desperate for yield, saw those comments—as well as some other encouraging developments subsequently—as a green light to take more risk

But in the closing days of September we’ve seen that optimism falter following some less positive headlines, including reports that the IMF might not agree to make further aid payments to Greece and that Greece might require a second restructuring.

As the chart below shows, government and corporate bonds of the troubled peripheral countries took off in late July, with spreads on Spanish government bonds tightening significantly relative to Bunds. In the high-yield market, as of mid-September more than 25% of the Barclays Capital Pan-European High-Yield index was yielding less than 5%. We saw a number of single B credits trading under 5%, with BB credits often yielding lower than 4%.

But by late September, spreads had started to widen sharply.

These developments are not surprising, and we think there’s potential for further spread widening. For one thing, with yields as low as 3% in the most expensive parts of the sub-investment-grade market, market pricing was not building in enough of a premium to compensate investors for the risks they ran.

Second, there’s no quick fix for the peripheral countries’ fiscal crisis. And it’s unrealistic to expect all the economic news to be good in the coming months. As our senior European economist Darren Williams argues, ECB bond purchases could help stabilize German business conditions and pave the way for a gradual recovery in 2013, but a big policy error could plunge both Germany and the rest of the euro area into a recession. So we’re not out of the woods yet.

Finally, one key test of the market may come in the next few weeks if pent-up financing demand from the high-yield companies starts to surface. Smaller non-investment-grade companies have struggled to access bank loans in recent years, and we have heard numerous reports of high-yield companies preparing to tap the bond markets. If market conditions permit, and we see a surge of new high-yield issuance, the increased bond supply could push spreads wider despite the strong investment demand we’ve been seeing in the high yield market. If economic growth doesn’t pick up, we could start seeing defaults by the more cyclically exposed players, which could mean a more significant repricing of risk.

What are the portfolio implications of all this? We’d be reluctant to bet on the more expensive high-yield names or the issuers that are heavily reliant on global growth. With part of the high-yield market still looking too rich, one possible strategy is to have some carefully selected high-yield and investment-grade nonperipheral subordinated financials on the one hand, combined with low-cyclical nonfinancial high-yield credits on the other. Many of these companies are in the process of boosting their balance sheet quality by deleveraging, have low exposure to the troubled peripheral countries and have business models that should be resilient if GDP growth remains slow. We’d expect this type of portfolio to offer a good level of diversification and, in current market conditions, yield around 8% on average—which we’d consider adequate to compensate investors for owning European high yield.

 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Jorgen Kjaersgaard is Head of European Credit Portfolio Management at AllianceBernstein.

© 2012 AllianceBernstein

 

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