European credit markets have hardly responded to the reports about the second coronavirus wave gripping the continent. This does not mean investors are complacent, according to Richard Ford, head of corporate bonds at Morgan Stanley Investment Management. Credit markets have been in waiting mode for a while, and have good reasons for it.
The Barclays Euro Aggregate Corporates Index has risen by almost 10% since its low at the end of March, but the asset class is still not very expensive, according to Ford. ‘Credit spreads are indeed below the long-term average, but still above the levels seen at the beginning of this year,› he told Investment Officer.
ECB backstop
And thanks to the ECB, the demand for corporate bonds remains strong. The bank’s PEPP has put a floor in the market, so investors in corporate bonds do not have to panic straight away about the worsening economic news of recent weeks. ‘The ECB has communicated to the market that there is sufficient additional capacity to expand the buy-back programme if needed,’ says Ford. ‘And governments› support programmes are also helping to keep businesses afloat.›
That support allows investors to look beyond the macro uncertainties of the coming months, explaining the relative calm in the credit markets. ‘We are assuming with the market that there will be a vaccine in six months› time and that the results of the US presidential election at the end of the year will be known.’ That, he says, is why the market hardly seems to be responding to the renewed advance of the Covid-19 virus in Europe and the US. Once that vaccine is in place, civil unrest in the US does not escalate and the Brexit storm has subsided, the market can move on, Ford expects. ‘Until then, however, the credit markets will be in waiting mode and we expect volatility to remain limited.’
Ford emphasises that the current crisis is ‹transitory›. ‘But that does not mean you can ignore it, because it is simply too big for that. We too divide the market into companies that are directly affected, such as tourism, business travel and retail and office property, and companies that are not.›
But that does not mean that Ford avoids those badly affected sectors. On the contrary: ‹We have a small overweight for companies that have been directly affected, but are likely to survive the crisis.’ For example, Ford still has the nerve to buy airport debt securities. ‘Airports are now suffering heavy losses, but they are assets of strategic importance [to governments], so they will be kept afloat in most cases.›
Adaptability
But the most important factor to or not to invest in a company’s bonds is not the sector in which a company operates, but its business model. ‘We find companies with high fixed costs less attractive, so we prefer not to invest in them,’ says Ford. ‘If a company sees its profitability fall, this is not necessarily an insurmountable problem for bond investors. The issue is whether a company can quickly adapt to this new reality, for example because it has room to cut the dividend or the investments.’ Companies with low fixed costs generally succeed better in this, in Ford’s experience.
Finally, Ford prefers companies with an ‹optimal financing structure›. In practice, this means companies that have optimised their balance between equity and debt. ‘Companies can finance themselves with equity or debt. Debt is, certainly in recent years, a lot cheaper.› Ford therefore has a preference for companies that issue debt. ‘Many companies have also structurally increased their debt levels, simply because this is the cheapest form of financing. This is also the main reason why the credit quality in the investment-grade universe has deteriorated considerably in recent years. Many companies have gone from an AA rating to A or from A to BBB because their debts were increasing, but this was often a deliberate, strategic choice.’
Fallen angels
Yet many investors look with suspicion at European corporate bonds, precisely because of the over-representation of BBB credits, the lowest investment-grade category. Certainly in the event of continuing economic headwinds, downgrades to high-yield, as happened during the first coronavirus wave last spring, remain present.
‘Everything depends on how the credit rating agencies respond to this,’ says Ford. ‘During the first wave, they reacted fairly quickly by downgrading companies that were directly affected. But now I see that the credit rating agencies are in waiting mode, just like investors in fact. They have expectations about the performance of companies in 2021, and if they do not live up to these expectations, then you may see further downgrades.’ But not in the immediate future, expects Ford.
And if companies do become falling angels, that need not be an immediate disaster. ‘Nowadays, there is a structural demand for high-yield bonds. As a result, you see that corporate bonds often perform surprisingly well after a downgrade.›
With €4.2 billion in assets under management, the Morgan Stanley Euro Corporate Bond Fund (LU0851374255) is one of the larger European corporate bond funds. The fund invests primarily in investment-grade corporate bonds issued in euros, but can also hold a small proportion of high-yield and (semi)-government bonds. The fund is slightly more volatile than the benchmark: in years with a positive return, the fund tends to outperform its benchmark. In negative years, such as 2018, it is usually the other way around. This is due to the fund’s slight preference for BBB bonds. Year-to-date, the fund stands at a return of +1.05%, compared to +0.92% for the Bloomberg Barclays Euro Aggregate Index.