The slowing debt cycle, tighter credit spreads, and lesser central bank support entice us to take a rather cautious and neutral view on the corporate bond universe. We take note that the investment-grade segment has consistently suffered during the sharp rise in US rates and is more vulnerable than high yield, especially as spreads have been consistently tightening and are at extremely low levels. The high yield asset class has seen some outflows over the past few months as investors look to take profits. In Europe, there are some relative value opportunities in BB rated bonds, as European high yield includes 10% of rising stars, and in the financial sector, which will benefit from steeper rates.
We continue to overweight the financial sector vs. non-financial sector, which benefits from stronger fundamentals and relatively attractive valuations (though spreads are narrowing rapidly and are at low levels). The financial sector is also supported by improving capital reserves (and asset quality), wider margins on the back of rising interest rates, as well as the regulatory landscape. The banking resolution laws were put to test recently as two banks (Banco Popular & Vincenza and Veneto Banca) were declared as “failing or likely to fail”. In both cases, deposits and senior debt holders were protected as the losses were borne by subordinated debt and equity holders. While maintaining European financial stability is the main objective, we are still in a transitory period regarding implementation of the Banking Resolution & Recovery Directive, and in some cases, like in Italy, the political response may differ according to the interpretation of the law. Within the financial sector, we are maintining our investment focus on cocos, which benefit from earnings recovery, lower duration, and weaker correlation to US Treasuries. In terms of yield, these instruments are matching the levels presented by US high yield credit.