Quick view: The ECB‘s back-to-back cuts and what this means for corporate credit
A consecutive rate cut from the European Central Bank (ECB) shows the different pace of monetary policy easing cycles globally. Client Portfolio Manager Celia Soares explores what this means for Euro investment grade credit.
4 minute watch
Key takeaways:
- The ECB cut its interest rates by 25 basis points, the first consecutive cut in over a decade, as it believes that the disinflationary process is “well on track” and given signs of broad-based economic activity weakness.
- There is significant growth dispersion across Europe and the ECB’s focus appears to have shifted to support the core economies, which are facing growth challenges. The periphery economies, in contrast, have shown unexpected strength.
- Strong corporate credit performance, however, has not left much dispersion in spreads. As active investors, we seek to uncover attractively priced yield opportunities and the potential beneficiaries of cheaper access to capital.
A spread percentile is a measure of the distribution of credit spreads that divides data into 100 equal groups. It indicates the percentage of data that is equal to or below a particular value. By comparing the 90th to 10th percentile of values, this can indicate the level of dispersion between spread values.
Basis point (bp): One basis point equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Credit spread compression: This happens when the yield differences between government bonds and other bonds that share the same maturity shrink.
Disinflation: A fall in the rate of inflation.
Credit spread is the difference in yield between securities with similar maturity but different credit quality, often used to describe the difference in yield between corporate bonds and government bonds. Widening spreads generally indicate a deteriorating creditworthiness of corporate borrowers, while narrowing indicate improving.
Disinflation: A fall in the rate of inflation.
Dispersion describes the extent to which a distribution of datapoints is stretched or squeezed. If the datapoints cluster around certain values, then dispersion is low. If they are more spread out, then dispersion is high.
Gross domestic product (GDP): The value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). When GDP is increasing, people are spending more, and businesses may be expanding, and vice versa. GDP is a broad measure of the size and health of a country’s economy and can be used to compare different economies. Real GDP is a measure of the value of all goods and services produced in a given year, adjusted for inflation.
High yield bond is a bond with a lower credit rating than an investment grade bond, also known as a sub-investment grade bond, or ‘junk’ bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher interest rate (coupon) to compensate for the additional risk.
Inflation: The rate at which the prices of goods and services are rising in an economy. The Consumer Price Index (CPI) and Retail Price Index (RPI) are two common measures. The opposite of deflation.
Investment-grade bond is typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Loan delinquency occurs when a borrower is late on a loan payment or misses a payment entirely.
Monetary policy cover the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money.
Primary/core economies: The core is central region in an economy, considered as such due to its dominance and prosperity, compared with good communications and high population density, which conduce to its prosperity—is contrasted with the periphery—outlying regions with prosperity, reflected in unemployment. The core countries include Austria, Belgium, Germany, the UK and France. The periphery is traditionally considered to be Portugal, Italy, Ireland, Greece and Spain.
Technical analysis focuses on statistical trends in the stock’s price and volume over time
The IHS Markit iBoxx EUR High Yield Index is designed to reflect the performance of EUR denominated sub-investment grade corporate debt.
The IHS Markit iBoxx® EUR index represents the investment-grade fixed income market for EUR-denominated bonds. The index rules offer broad coverage of the EUR bond universe and maintain minimum standards of investment viability and liquidity.
Yield is the level of income on a security over a set period, typically expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
There is no guarantee that past trends will continue, or forecasts will be realised. Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
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Celia Soares Central banks across the globe are cutting rates at different paces. The European Central Bank, ECB’s decision was to deliver a consecutive cut, given the downside risks to economic growth. This reflects other risks on the horizon, such as labour weakness and trade tensions. The ECB didn’t drop its language of keeping policies restrictive to reach the 2% inflation target, as some expected. It kept its data-dependent approach, and to make decisions meeting-by-meeting.
ECB’s President Lagarde pointed to the weakness across economic indicators. Europe’s primary or core economies are showing signs of weakness, particularly in core countries such as Germany and France. A persistent downturn in manufacturing, coupled with stagnant growth in construction, has left the service sector as a key source of economic expansion. Countries with a heavy reliance on manufacturing have seen poorer performance lately, with Germany’s economic growth ranking amongst the lowest in the region over the past five years, except for 2020.
However, a focus on the headline levels overlooks the macro dispersion that exists between countries in the bloc. The periphery is coming up strong, with positive growth, illustrated by Spain in particular, and also by Greece and Portugal. It’s also resulted with several peripheral country bank ratings being upgraded. In previous cutting cycles, the ECB aimed to stabilise peripheral bond spreads, however this cycle the focus has shifted towards supporting core economies.
So what does that mean for corporate credit? Rate cuts are positive for total return dynamics, as a fall in yields contributed to capital gains for bond investors. Aside from Q4 for 2023 and the COVID-related rally back in Q2 2020, you have to go back 12 years to find a better quarter for the total returns in euro investment-grade credit. As a result, there has been a decline in dispersion in the euro IG markets, and for active investors, it is about picking the winners from those benefiting from cheaper access to capital.
Some sectors could benefit more than others from the falling rates, such as real estate and utilities, but for others, the relationship is more nuanced. Bank profits are affected by lower rates, but fewer loan delinquencies are also a positive. European banks tend to be less sensitive to the impact of interest rate moves than their counterparts in the US, and often have hedges in place to manage that risk. Given tight spreads, a risk-off scenario could see spreads widen in pockets, like we have seen in the auto sector.
Despite strong performance for investment-grade credit, high-quality IG credit still appears cheap versus the broader euro IG market. As a positive for spreads, flows tend to follow returns. Historically, after the first cut, flows tend to go into IG credit relative to euro high yield, and this has been the case thus far in this cycle.
Risks such as political remain on the horizon, but yields also remain attractive. In our view, security selection will be key to returns. In other words, picking the right levels of yield to reflect risk.
We will keep monitoring the developments of monetary policy and credit markets to keep you connected.
Related insights
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
There is no guarantee that past trends will continue, or forecasts will be realised.
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Important information
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
4 minute watch
Key takeaways:
- The ECB cut its interest rates by 25 basis points, the first consecutive cut in over a decade, as it believes that the disinflationary process is “well on track” and given signs of broad-based economic activity weakness.
- There is significant growth dispersion across Europe and the ECB’s focus appears to have shifted to support the core economies, which are facing growth challenges. The periphery economies, in contrast, have shown unexpected strength.
- Strong corporate credit performance, however, has not left much dispersion in spreads. As active investors, we seek to uncover attractively priced yield opportunities and the potential beneficiaries of cheaper access to capital.