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EUR short-term credit: low duration response to negative rates

Fixed Income Monthly
August 2017

Justine Vroman, Investment Manager

The prospect of tighter monetary policy and a solid corporate backdrop support EUR short-term credit as a higher-yielding alternative to cash

The investment climate facing European fixed income investors seems to be tough. Against this backdrop, how do you think investors could benefit from having EUR short-term investment grade credit in their portfolio? 

JV: Investors in European bonds appear to be in a quandary. On the one hand, negative deposit rates mean holding cash is a painful option and investors are forced to search harder for yield. At the same time, however, long-term debt does not look particularly attractive as Europe’s robust recovery will push the European Central Bank to normalise its monetary policy, a move that could lead to higher long-term interest rates.

Prior to this negative rate environment, investors had the comfort of knowing that keeping cash as an investment would yield at the very least a positive return. Today, however, the opportunity cost of cash is negative as custodian charges eat into your capital and EUR3.2 trillion of assets are yielding below zero.1

negative blues

EUR Overnight Rate (EONIA), %

EIR Overnight Rate EONIA
Source: Pictet Asset Management, Bloomberg, as at 31.07.2017

This search for yield has benefited the EUR short-term investment grade credit market, which has attracted EUR16 billion since March 2016. However, this is not the end of the story.

Interestingly, flows into the asset class have accelerated after the US presidential election, just as expectations for higher long-term interest rates intensified. This underscores what I believe to be another key driver of short-term credit: a flight from duration.

Short-term investment grade credit offers a higher-yielding alternative for investors who have the flexibility to switch out of cash. The yield for Pictet-EUR Short Term Corporate Bonds strategy stands at 0.25 per cent for a duration of 1.85 years, compared with -0.35 per cent for cash.2

consistent long-term return

EUR investment grade 1-3Y, total return

EUR Investment Grade Performance

Source: Pictet Asset Management, Bloomberg, BofA Merrill Lynch benchmark, as at 31.07.2017

Although credit is more volatile and less liquid than cash, it offers an avenue of diversification, since cash deposits have a concentrated custodian risk. Furthermore, the front end of the yield curve is typically where the slope is the highest, hence offering the best value for every additional year of duration. 

EUR short-term investment grade credit has a shorter duration than its broader all-maturity counterparts. This means investors can reduce risks from tighter monetary policy by lowering volatility and sensitivity to interest rate hikes. Currently, investors can reduce duration by 3.4 years by giving up just 21 basis points of spread and switching to short-term bonds from the all-maturity counterparts.3

 All in all, short-term credit has an attractive trade-off for investors who face a dilemma of having to seek yield but avoid long duration.

How do you think the ECB's monetary policy would impact the short-term investment grade credit market? And what's your take on the health of the companies in your investable universe?

JV: We expect the ECB will take a gradual approach in normalising its monetary policy by reducing the size of bond purchase first before raising deposit rates. Therefore, we expect short term rates will remain negative for some time – so carry is still your friend now. Here, our active approach in finding the right spot on the front end of the curve allows us to add value.

Credit spreads could widen slightly on the ECB’s tapering; but we don’t expect a dramatic repricing and the front end should be shielded.

Investors in the short-term investment grade credit market will benefit from improving corporate fundamentals. European investment grade companies have reduced debt in the wake of the financial crisis and they have ample cash on their balance sheets. Improving growth and low funding costs will support credit metrics. Moreover, from our conversations with company management, we get a sense that they are still cautious in deploying this cash on M and A deals and less aggressive compared with previous cycles.

We expect short-term rates to remain negative for some time - so carry is still your friend now. 

What is your approach to the short-term investment grade credit market?

JV: The Pictet-EUR Short Term Corporate Bonds strategy aims to offer a stable risk profile with limited drawdowns. Investors benefit from our conservative approach that employs strict duration management. We invest in highly liquid bonds from pure investment grade credit, mainly with maturities of one to four years. The four- to six-year maturity debt makes up no more than 10 per cent of the portfolio and we have no investments beyond six-year maturities, unlike some of our peers. We can invest up to 15 per cent in BBs which allow us to enhance diversification and yield.

Since the inception of the strategy in November 2013, we have been through a number of risk events – including the Greek debt crisis mid-2014, Chinese hard-landing fears followed by a commodity sell-off in 2015 and early 2016, as well as Brexit. Yet our disciplined approach has enabled the strategy to deliver steady returns of 1.9 per cent per year for volatility of 0.6 per cent.4

How is your strategy positioned for the coming months? 

JV: The European credit market has enjoyed a strong rally in the past few months, which has reduced spreads to 94 basis points from 124 bps in December.5

Since valuations offer less upside now, we are taking a more measured approach – focusing on carry positions, taking profits in sectors and issuers where we see limited room for spreads to tighten, and limiting duration risk given the recent volatility in rates.

We have reduced our off-benchmark positions by limiting exposure to four to six year maturity bonds below 3 per cent and having BB exposure of around 6.5 per cent, less than half of our limit.

In terms of allocation, we are focused on a number of themes where the long-term prospect of higher interest rates is one of the main drivers:

  • Financials: we favour the sector as the prospect of a steeper curve is positive for insurers and banks; the deleveraging progress in Italian and Spanish banks is also encouraging. We express this view through subordinated bonds from core European banks and large and diversified insurers
  • Consumer-related sectors: higher interest rates could be a drag; we are also cautious on retail companies as the sector at a global level is exposed to disruptive forces where changing consumer behaviours put some business models at risk
  • Autos: we are highly selective in the auto sector, especially for issuers exposed to the US market which appears to be in the late cycle. We hold senior bonds from auto manufacturers and auto part makers alongside rising stars – issuers with the ability to move to investment grade in the coming months – and some hybrid debt.