Asset allocation update – rise in European investment grade

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Strong financials and attractive market valuations 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 built a position in the European IG steadily this summer. Here are the four main reasons for our extension.

Of fundamental perspective,

  • corporate cash balances are high and rising
  • interest coverage is at historic highs (even in the most struggling companies and sectors such as chemicals and automotive)
  • a period of strong deleveraging is now behind us, leaving surprisingly low leverage.

Compared to previous periods of stress (such as an impending recession or rising interest rates), this market segment now appears to be in better shape. In terms of valuations, there is a deep disconnect between market prices – IG bond prices are at multi-year lows – and expected levels of default, even in the worst case. As noted, fundamentals such as cash balances and interest coverage are strong, not warranting spreads at 2020 levels (see Table 1) or an implied default rate of 9%. While credit spreads (and swap spreads) are expected to tighten, we believe IG Euro bonds are now attractively priced relative to equities.

Market techniques also seem favorable: the shift from exits to entries in recent weeks could have “legs”. Further support should come from expectations that 12% of BB+ (junk) rated European bonds will move 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 debt can act as stress buffers. Since there is no apparent need to “fix” cash or debt levels, there is no pressure on companies to engage in credit-damaging deleveraging.

Views of asset classes at the end of August

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. All opinions expressed herein 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 have different views and make different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns. Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as 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 developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.

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