European Fixed-Income Outlook: Stay High Quality In 2023

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By Vivek Bommi, CFA

European bond-market show was among the worst connected grounds successful 2022, arsenic Europe ran the gamut of geopolitical, economic, and marketplace storms. While problems persist and we expect further periods of volatility, we judge the worst interaction connected markets is past and that investors volition find opportunities successful 2023 - peculiarly successful investment-grade and prime high-yield credit.

With a batch of atrocious quality already priced into recognition markets, yields look compelling to america astatine existent levels. Starting yields person historically been reliable indicators of aboriginal recognition returns implicit a three- to five-year horizon. On that basis, yields1 of 4.3% for euro-denominated investment-grade recognition and 7.8% for precocious output connection charismatic risk-adjusted imaginable returns.

Outlook for European Corporates Brighter than Feared

European economies are entering a pugnacious play successful 2023. But we don’t deliberation Europe faces an situation arsenic atrocious arsenic during the planetary fiscal crisis. Developments successful caller months person been amended than expected. An assertive effort to rebuild earthy state stockpiles and a lukewarm commencement to the wintertime play person constricted the hazard of vigor rationing, reducing the probability of a terrible economical downturn.

Accordingly, we expect a shallow recession with rates plateauing towards the extremity of the year. While that script whitethorn beryllium somewhat challenging for equity investors, we deliberation that indebtedness issued by high-quality companies should bash well.

Euro-denominated credit has entered the existent pugnacious play successful bully cardinal shape, making it resilient to aboriginal storms. Corporate margins and leverage person recovered from the COVID exigency play and returned to semipermanent mean levels, and net and currency flows should stay capable to support bondholder payouts.

Across some concern people and precocious yield, recognition spreads are supra mean and implicit full yields look attractive. We whitethorn spot immoderate further dispersed widening successful recognition markets arsenic economies slow, but existent output levels supply a important buffer against near-term losses (Display, below).

Euro Credit Yields and Spreads Look Attractive

Yields and Spreads Are Above Three-Year Average successful Each Category

Current and humanities analyses bash not warrant aboriginal returns. As of December 27, 2019, done January 4, 2023. (Source: Bloomberg. EUR IG: Bloomberg Euro Aggregate Corporate Index. EUR HY: Bloomberg Pan-European High Yield (Euro) Index. EUR BBB: Bloomberg EuroAgg Corporate Baa Index. EUR BB: Bloomberg Euro High Yield BB Rating Only Index. EUR B: Bloomberg Euro High Yield B Rating TR Index. EUR AT1: based connected the EUR subset of the Bloomberg Global CoCo Tier 1 Index.)

Meanwhile, we similar the higher prime segments of the euro recognition markets, arsenic these connection the champion extortion against concern downturns. Specifically, we favour the BBB- and BB-rated parts of the markets, and we similar prime high-yield areas specified arsenic subordinated slope credit. European banks’ equilibrium sheets are beardown aft a decennary of tougher regulation, banks payment from rising rates, and their subordinated indebtedness (mostly Additional Tier 1 bonds, oregon AT1s) looks cheap. By contrast, we look to debar riskier firm credits - peculiarly successful cyclical industries, wherever spreads whitethorn widen astir - and lower-rated securitized bonds. The second held up good successful 2022 and are exposed to the hazard of a hard economical landing that could weaken the lodging marketplace and wounded user equilibrium sheets.

Interest Rates to Peak successful 2023

While some the European Central Bank (ECB) and Bank of England (BoE) are committed to further increases, we judge the play of assertive interest-rate hikes and related shocks for investors is apt implicit and that rates volition highest astatine astir 3.0%–3.5% successful the eurozone and 4.5%–5.0% successful the UK (Display, below).

Markets Are Expecting Rates to Stabilize successful 2H 2023

Current investigation does not warrant aboriginal results. Implied rates are based connected guardant scale swaps As of January 4, 2023 (Source: Bloomberg)

Slowing ostentation and much unchangeable monetary argumentation should trim interest-rate volatility, and little volatility typically favors higher-yielding assets. It is apt that the thrust volition stay bumpy astatine slightest for the archetypal fewer months of the year, but the wide outlook for markets has improved importantly successful the past fewer months, and we expect that inclination to clasp for 2023 arsenic a whole.

Cost of Hedging Is an Important Factor

The precocious outgo of hedging US dollars into euros - present 2.5% versus conscionable 0.8% astatine the opening of past twelvemonth - volition astir apt again support euro investors astatine location (Display, below).

European IG Credit Offers Euro Investors Value vs. US

Yields to Worst Adjusted for the Cost of Hedging

Past show does not warrant aboriginal results. EUR IG represented by the Bloomberg Euro-Aggregate Corporate Index; US IG little three-month hedge outgo represented by the Bloomberg US Corporate Index little the outgo of a rolling three-month currency hedge Through December 30, 2022 (Source: Bloomberg and AB)

Conversely, euro markets whitethorn connection charismatic opportunities for US-dollar investors connected a currency-hedged ground since antagonistic hedging costs for US investors volition heighten euro yields. We deliberation euro-denominated investment-grade credits person peculiarly beardown fundamentals and connection a compelling diversification accidental for US investors.

Balanced Portfolios May Make for Better Risk-Adjusted Returns

We person agelong advocated an attack that dynamically manages a portfolio’s vulnerability to involvement complaint and recognition risk. Such an attack tin harvester sovereign and different higher-rated indebtedness with noninvestment-grade credits successful a single, risk-managed portfolio with a presumption to improving risk-adjusted returns.

That operation looks peculiarly invaluable arsenic we participate a perchance choppy 2023. Both UK and euro-area authorities and investment-grade bonds are starting the twelvemonth with importantly higher yields than successful caller history, providing greater upside imaginable successful aboriginal risk-off periods. And higher-yielding recognition tin lend comparatively precocious returns erstwhile markets are stable.

We deliberation that this benignant of balanced portfolio attack tin seizure astir of the imaginable instrumentality provided by high-yield markets, but typically with smaller drawdowns than a dedicated high-yield portfolio. It tin besides assistance supply liquidity successful times of marketplace stress. By adopting this risk-mitigating approach, investors tin readily rebalance from higher-priced investment-grade securities into high-yield credits erstwhile charismatic introduction points arise.

We expect that the complexity and assortment of European markets volition supply further opportunities for progressive investors successful 2023. The euro country remains astatine the forefront of environmental, societal and governance investing, and we spot further prospects to adhd worth done skillful information enactment based connected rigorous investigation of greenish and different ESG-labeled enslaved issues.

A dynamic attack volition stay key, arsenic gains and setbacks whitethorn reverse rapidly successful a volatile environment. And the quality to put tactically has the imaginable to adhd further worth successful a precise divers region. After the setbacks of 2022, we deliberation investors - and yields - are starting 2023 successful a much promising place, and we are optimistic that risk-aware positioning successful European recognition volition beryllium rewarded successful the coming months.

1 As measured by output to worst. All information shown are arsenic of December 30, 2022.

The views expressed herein bash not represent research, concern proposal oregon commercialized recommendations and bash not needfully correspond the views of each AB portfolio-management teams. Views are taxable to alteration implicit time.

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