By Edward Farley, PGIM Fixed Income
While we believe the underlying tone of the European corporate bond market has been constructive so far in 2017, political undercurrents are flowing faster in the run-up to several national elections across Europe.
France took the spotlight in February as electoral rhetoric and poll results led to growing concern over a more populist agenda. French sovereign and corporate bond spreads both rose sharply, with the peripheral markets following suit. In fact, 10-year French sovereign yields converged with those of similar-maturity Ireland bonds for the first time in 10 years.
As much as political noise is spurring market volatility, and will likely continue to do so, we note that from a relative value perspective, the ripples from these periodic events can also provide attractive entry points, especially considering still favourable fundamentals and a host of stabilising technical tailwinds. The negative interest rate policies of the European Central Bank and Bank of Japan continue to steer investors toward higher-yielding securities, and the ECB and Bank of England’s corporate bond purchase programs provide a strong underpinning.
At this juncture, the markets are still encouraged by the ECB and BoE’s assurances that they will remain accommodative to keep the economies on track, despite uncertainty surrounding the timing and potential fallout as central bank support fades. In the U.S., meanwhile, the Federal Reserve is signaling a series of short-term rate hikes over the next several years, and the new administration is expected to initiate a potential inflation-fueling economic stimulus package.
Even against these backdrops, both U.S. and European corporate spreads narrowed sharply over the past 12 months, as is illustrated below. Considering these cross currents and tighter spreads levels, should the developed corporate markets be ‘risk on,’ ‘risk off,’ or just more diligent?
Consider exploiting cross-border inefficiencies
Rather than a hard stop, we note that a more diligent, actively managed approach across developed market corporates can still add value. Adding carefully-researched, fundamentally sound credits following a period of spread volatility can take advantage of inefficient market pricing, especially across regions and currencies. By considering cross-border relative value opportunities in the euro, sterling, and USD corporate bond markets, investors can uncover price discrepancies for the same or similar credits caused by different economic, market, and technical conditions and lack of name recognition. Add to that varying political backdrops, regulatory and tax policies, and eligibility for central bank purchase programs, and the opportunity set multiplies.
These opportunities have become even more pronounced given the volume of non-euro and U.S.- based, reverse yankee companies issuing in the lower-yielding European markets— more than €124 billion, or about 43% of total issuance, in 2016. These credits are often priced at discounts to where they trade in U.S. dollars and offer a generous spread pick-up over similar-quality euro or sterling debt. Over time, we would expect the market to price these issues more efficiently as technical unwinding can lead to attractive, long-term opportunities.
The ‘all in’ borrowing costs of these cross-border trades can vary depending on interest rates, foreign exchange rates, and market spread levels. In many instances, issuers appear to have been much more rate sensitive than spread sensitive.
For example, a U.S. motion and control technology company came to market in February 2017 with a multi-currency deal. Its 10-year USD issue priced at a euro-adjusted level of mid-swaps +21 bps, compared to an 8-year euro-denominated issue priced at mid-swaps +65 bps—a curve-adjusted difference of almost 50 bps in favor of the euro issue.
In December 2016, a U.S. orthopedics firm issued a 10-year bond in euros at mid-swaps +168 bps, a discount of more than 50 bps compared to a similar-maturity bond from the same issuer trading in the U.S. secondary market. Plus, unlike the U.S. issue, the euro bonds have a coupon step up if downgraded to high-yield status.
And in November 2016, a U.S. multinational pharmaceutical company issued debt in the euro market at spreads 100 bps wider, on a cross-currency adjusted basis, than a similar maturity bond from the issuer in the U.S. secondary market. Actively managing a global corporate portfolio’s risk exposures based on technical shifts, including politically-driven fallouts, can also add value. For example, shifting risk to non-eurozone and U.S. reverse yankee issuers when the ECB and BoE corporate bond purchase programs compressed euro spreads to less attractive levels.
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