2024 European Credit Outlook

Nicola Mai

So, Charlie, obviously a key question that people are asking is what is the macro-outlook for the European economy over the next 6 to 12 months? I would say that we are already in a weak economic situation and we expect that weakness to continue.

As a result, I think the ECB is done tightening and looks set to cut rates, probably cautiously initially, given that they want to make sure they win this fight against inflation. But rates are certainly on the way down from our perspective.

Charles Watford

I think with that backdrop, credit looks an interesting opportunity. First of all, the starting leverage, the starting conditions for the majority of investment grade and high yield companies are in good places. So leverage is low. There's been a lot of preparation for a recession on the corporate side for really the last two years, and you can see that in the high yield market where 65% of bonds are rated BB versus only 5% rated CCC.

The second point I think is important, is that we are seeing more credit rating upgrades than downgrades in this environment and growth has been weak last year as well. And it's really because corporates in this higher rate environment are taking the decision to deleverage, to reduce their cost of debt and reduce the amount of debt - and again, that's positive for a lot of companies, BB's for example going to investment grade.

Nicola Mai

One of the questions, obviously, that we get asked a lot is what does this macro outlook mean for markets and European bond markets specifically? And in that context, I would say that European interest rate risk here looks very attractive. You know, we have the highest level of yields we've seen in over a decade.

And I think history suggests that there is a high correlation between the level of yields and the returns on fixed income. So I think this is a very good starting point. And maybe the final point I would make is that cash has been king, you know being in cash has been great, but yields in cash are fleeting. They're high today, they're probably not going to be high tomorrow - so I think it is time to lock in some of these yields by adding some duration exposure to portfolios.

Charles Watford

Absolutely, and as you say, as investors move out of cash into other areas of the fixed income market, to earn better returns and more duration, investment grade credit is one of those areas that will benefit and also the high quality elements of the high yield market.

We can also see that despite what's been a good performance for credit in 2023, those valuations that you mentioned are still attractive.

A lot of companies, investors and management teams have been expecting a recession and a slowdown since as soon as the central bank started hiking rates. As a result, some of that risk premium of a recession is already in the markets, which therefore means that as an investor today, you are getting some compensation for that.

Nicola Mai

So, yeah, Charlie, when we think about European credit markets and portfolio positioning over the next year, my thoughts would be that credit markets are attractive here. You know, spreads are not particularly wide, you know, from a historical perspective, but the overall total return of the credit markets looks interesting to me.

Charles Watford

So if you look at where we're positioning portfolios at the moment, we find a lot of opportunities in credit upgrade candidates - so BB’s moving to investment grade where you can achieve 100 basis points of spread compression, which can give very attractive total return opportunities. The second area that we also see as attractive is those shorter maturity bonds.

And finally, from an asset allocation point of view, European high yield has provided better risk adjusted returns than the main European equity indices over the last 20 years, and so now with starting yields where they are, we have the potential to continue that over the next five years.

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