The opportunity in global credit

Eoin Walsh, Partner and Portfolio Management

Bond investors now have many reasons to be optimistic and, after relatively significant bouts of market volatility and central bank rate hiking, we think the pieces are in place for the European bond market to provide stellar returns to investors.

In our view, yields on offer in fixed income are the most attractive they have been for a long time, particularly in Europe, where the yields on high-quality bonds have returned in a relatively big way after a few years of languishing at just 2% or 3%.

The end of rising interest rates in Europe and the US, attractive yields, and lower-than-expected default rates mean investors can get the income they want without having to take on as much risk as they once had to in the past. They should no longer need a combination of high-risk strategies to achieve attractive returns, with most now able to find what they need in less volatile, high quality, fixed income products.

The base case for most investors, including our own house view, is one of a soft landing or below trend growth in the US, while a mild recession is expected in Europe. And, with inflation falling, this should encourage the European Central Bank (ECB) to cut rates sooner rather than later. In these scenarios, credit should perform well. What is traditionally bad for credit is a hard landing coupled with spiking default rates, which is not the base case for most strategists.

All of this, coupled with the fact that strategies such as European asset-backed securities (ABS) and Additional Tier 1 bonds (AT1s), are tipped once again to be strong performers for investors in 2024, as well as great diversifiers, means the European bond market is gaining a lot of attention.

Strong momentum in the European ABS market

In our view, the European ABS market has been a strong performer over the last couple of years, providing significant inflation protection, low defaults, and transparency. Its reputation was unnecessarily tarnished during the 2008 global financial crisis, but it has since delivered unrivalled recent results within fixed income.

What makes ABS stand out compared to conventional bonds is that they are ‘secured’ against a diversified pool of loans with similar characteristics, such as mortgages, credit card debt and car loans. But the European market is also very different to the US.

The biggest misconception, in our view, is that the European and US versions of ABS are the same but, although they may share the same acronym, there are fundamental differences between the two, including higher lending standards, the availability of borrower recourse, and a much greater alignment of interest between issuers and investors.

The result is that the ABS market in Europe was actually able to perform exceptionally well during the financial crisis, while the US market suffered.

What is more, European ABS are virtually all floating rate, with near-zero interest rate risk, which means they’re expected to be far less volatile than fixed rate bonds when interest rates are rising. But, even in the current environment of predicted rate cuts, ABS continues to have a powerful role to play.

Central banks have said that they will pay attention to the data before deciding what to do with regards to rate cuts. Despite the recent price falls, commodity prices are on the up and other geopolitical risks exist, including the Russia-Ukraine war.

The result is that, despite expectations among some commentators of interest rate cuts in May, the picture remains far from certain, and rates could still be higher for a bit longer.

All of this adds up to the European ABS market offering strong yields, improved diversification, and a great deal of investor protection, meaning it should have a significant role to play within investors’ portfolios.

AT1s are poised for growth

Part of a family of bank capital securities known as contingent convertibles or ‘CoCos’, AT1s are bonds issued by banks that contribute to the total level of capital they are required to hold by regulators.

And, after a very difficult early part of 2023, AT1s have recovered strongly and are producing relatively stellar returns.

Confidence returned as banks continued to report very strong earnings and also continued to call their AT1s on their first call dates. In addition, when UBS came to the market in November, with its first AT1 deal since taking over Credit Suisse, raising $3.5bn, this proved to be a very important milestone for the market and investor confidence. In bringing the deal, UBS built an order book of $36bn, which is unheard of, not only in the AT1 space, but more broadly in general credit markets.

This, coupled with the fact that the European bank industry is arguably the most highly regulated in fixed income globally, that bank bonds offer a spread premium over corporate debt, bank fundamentals are strong, with upgrades far outpacing downgrades, means we see AT1s in Europe as very well set up for the remainder of this year.

European bonds are back in the spotlight

The upshot is that the fixed income market in Europe is once again demanding the attention of investors after a tricky period. Yields have returned, the economic outlook is bright and default rates are lower than many predicted.

And, at the same time, sectors, such as ABS and AT1s, which differentiate Europe from other markets, are making a significant impact and are providing important diversification for investors.