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Asset allocation update – European investment-grade upped

Solid financials and attractive market valuations have led us to add to our long position in European investment-grade (IG) bonds, reallocating assets away from European sovereign bonds (‘neutral’; see table below). We have been building a position in European IG steadily this summer. Here are the four main reasons for our extended long.  

From a fundamental perspective, 

  • company cash balances are high and rising
  • interest cover is at historical highs (even at more challenged companies and sectors such as chemicals and cars)
  • a spell of strong deleveraging is now behind us, leaving leverage surprisingly low. 

Compared to earlier periods of stress (such as an impending recession or rising interest rates), this market segment now looks to be in better shape. In terms of valuations, there is a deep disconnect between market pricing – IG bond prices are at multi-year lows – and expected default levels, even in a worst-case scenario. As said, fundamentals such as cash balances and interest cover are strong, not justifying bond spreads at 2020 levels (see Exhibit 1) or a implied default rate of 9%. With credit spreads (and swap spreads) expected to narrow, we believe IG bonds in euros are now valued attractively versus equities.

Market technicals look favourable too: the turn from outflows to inflows in recent weeks may have ‘legs’. Further support should come from expectations that 12% of European BB+ (junk) rated bonds will be upgraded to IG over the next year, adding rising stars to the segment.

Finally, the current cycle should be different. As the economy slows down, high cash balances and low leverage can act as anti-stress buffers. Given that there is no apparent need to ‘repair’ cash or debt levels, there is no pressure on companies to engage in credit-denting deleveraging.

Asset class views as at end-August

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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