Buckle up, bond investors.
Global reflation and fading central-bank stimulus herald a new dawn for the European corporate debt market that will buoy high-yield paper at the expense of high-grade, according to analysts at Bank of America (BofA), citing an upcoming portfolio shift among investors.
“In 2016 we saw the lowest in yields and spreads,” strategists at the U.S. bank led by Ioannis Angelakis, wrote in a report this week. “We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe.”
Monetary stimulus will reach “peak strength” this quarter, the strategists note, citing the prospect of US interest rate rises and suggestions that the European Central Bank could wind down, or taper, its stimulus program as early as this year.
As the era of central-bank support fades, yields are poised to rise across European fixed-income. While that bodes ill for credit overall, it does mean debt sold by companies with more fragile balance sheets should outperform thanks to a protective cushion of higher spreads relative to investment-grade paper, Bank of America said.
The analysts point to the record divergence between corporate bond spreads and rising euro-area headline inflation as evidence that debt markets have yet to respond to the prospect of rising price pressures that erode the real value of fixed-income exposures.
“Credit is mispricing the current headline inflation pick up,” they said.
Rising political risks triggered the worst January on record for euro-area government bonds, fueling higher yields on investment-grade debt in the region. By contrast, junk-rated bonds have demonstrated resilience, with yields in the Bloomberg Barclays Pan-European High Yield Index falling to an all-time low of 4 percent.
Increasing global inflationary pressures and rising interest rates will see a migration of flows to European high-yield credit, as investors pursue a barbell strategy, the analysts concluded. That refers to a portfolio-allocation process that favors assets at both ends of the risk spectrum, at the expense of obligations in the middle, such as investment-grade corporate bonds.
“In our analysis we find that the higher the yield one can source from the government bond market â€” deemed as â€˜risk freeâ€™ â€” the lower the need to hunt for â€˜quality yieldâ€™ via the investment-grade credit market.”
High-yield should continue to outperform investment-grade bonds in 2017, said independent credit strategist Suki Mann. “The credit markets seem to be ignoring the potential for higher inflation and tapering leading to higher underlying yields,” Mann, a former head of credit strategy at UBS AG, added.
To be sure, investor appetite for European credit remains strong, itâ€™s unclear whether a spirited increase in core inflation is on the cards amid muted wage gains, and any portfolio shift will take root over several years, the Bank of America strategists note.
But firming macroeconomic data is indicative of a looming shift in investor preferences that will likely diminish the hunt for â€˜quality yieldâ€™ and, as such, should drive the outperformance of lower-rated debt obligations, strategists at the US bank conclude.