2024 has been all about spread compression, with high-Beta, HY/subordinated and heavy credit-content debt (AT1s, corporate hybrids, LT2, HY) clearly outperforming the high-quality, low-Beta, SSAs/covered/senior and heavy rates-content asset classes. The reach for yield within credit has been unusually high in the past two years, compressing intra-market spreads (senior-sub, high-low rating etc.) to levels that are relatively extreme, even for this benign risk environment and level of spreads.
Credit continues to have a low Beta to macro data, even as interest rates respond to the news flow of the cutting cycle, as economic activity remains far from recessionary. This helps to explain the decline in credit spreads and credit volatility relative to the volatility in interest rates, leaving spreads far more stable than yields. But this also leaves spreads near YTD tights across most of credit, in both EUR and USD, just a few weeks ahead of the US elections. With blackout season in full swing in Europe, strong technicals are likely to keep spreads well anchored almost until 5 November.
Safe and senior credit is the cheapest across EUR IG. Virtually everywhere we look within IG, we see asset class compression, in defiance of the rates rally and slowdown risk. Cash price vs. spread product is exceptionally expensive, as is cyclical vs. non-cyclical, and BBB vs. single-A. The reach for yield within credit has been unusually strong in the past two years, compressing intra-market spreads (senior-sub, high-low rating etc.) to relatively extreme levels, even for this benign risk environment and level of spreads. With the Fed’s rate-cutting cycle having started in September and the ECB open, as we have already seen, to back-to-back rate cuts, we think now is a good time to add duration.
In keeping with the theme of favouring asset classes with a higher rates component in 2025, we would prefer the senior to the subordinated space, as in a potentially more complicated macro scenario, the rates component could more than offset the widening of credit spreads. In the senior and LT2 financials space, credit spreads represent between 20% to 33% of yields vs. 63% for EUR AT1. Moreover, in an uncertain rates normalisation environment, the potential credit spread widening will not be offset for junior layers, especially if cracks emerge in the Goldilocks scenario.
At this stage, spread compression appears exhausted, so looking ahead into 2025, it would be the time to play those asset classes with a higher rates component and/or where spreads are historically much wider on a relative basis than those in the credit market (SSAs/covered) or attractive on a Beta-adjusted basis vs HY/subordinated debt (senior IG), as rates yields will gradually decline as central banks continue to cut rates at a gradual pace through 2025.
Hence, we see 2025 as a year of spread decompression, where liquidity risk is down and fundamental risk is up. IG is usually more sensitive to liquidity risk (higher-duration, rates-like asset), while HY is more sensitive to fundamental risk (lower-duration, equity-like asset).
Most AMs we have met recently have been gradually selling their positions in the high-Beta asset classes (AT1s, Tier 2s, hybrids, HY) as room for further spread compression looks limited, the long short-calls strategy has run its course and all-in yields are no longer as attractive. It is not that they are negative in these asset classes, particularly as inflows continue in the credit space as long as yields are still attractive, but AMs are now long in cash/liquidity and waiting for the next opportunity to arise.
- European bank AT1s (and T2s) have rallied strongly YtD, with AT1s among the best-performing categories within credit this year. Bank capital spreads are nearing 2021 tights and recovering to levels seen prior to the CS AT1 write-down. We think this strong performance has been driven by investors’ recognition of the strong fundamentals of the European banking sector, which has witnessed significant improvements in profitability, bolstered by higher interest rates, while still experiencing benign asset quality developments and lower extension risk due to the use of tenders and expected calls. Although NPLs will be closely monitored in case of recession, investors expect European banks’ fundamentals to remain solid, consolidating the improvement of recent years.
In addition to spread compression, 2024 has also been a story of financials outperforming non-financials (NFCs) and Southern Europe (and particularly Iberia) outperforming core Europe. Regarding the first point, and despite the fact that the senior financials/senior NFC spread gap is at a 32-month low, the consensus view is that financials will continue to outperform. The reasons underpinning this view are:
- Better earnings season expected in banks than in NFCs, as we are already seeing in the first days of the 3Q24 earnings season, where earnings have been more of a mixed bag for NFCs, while US banks and the first European banks reporting are still posting strong results, with a slight decline in NII/NIM more than offset by higher fees & commissions and strong CIB activity, while the cost of risk remains at cycle-lows;
- Given banks' strong results since 2023, following tightening by major central banks, the removal of that premium is not overdone as it looks to be Europe's healthiest sector now (in terms of profitability and credit metrics), and its outperformance on the equity side this year (the leader, with over 20% performance YtD) is clear evidence of that. The easing of monetary conditions and expected steepening of the yield curve is another positive catalyst for banks to maintain high credit standards, hence the outlook appears positive;
- NFCs’ high refinancing needs in 2025-2026 as the debt issued in 2020-2021 matures and there is delayed issuance activity from NFCs to benefit from lower rates;
- NFCs will be more affected than financials by the temporary 'Robin Hood' taxes under discussion in Europe (already announced in France, under discussion in Italy);
- Impact of the potential tariffs imposed by the US on a number of sectors in Europe; and
- NFCs more exposed to the weak macro/internal demand backdrop in China.
Regarding the “periphery is the new core” mantra, we continue to see further momentum in Southern Europe in 2025. Regarding the potential impact of the French dynamics on Iberia and Italy, our view is that moderate further widening pressure on French assets would have a muted impact on Iberian assets, which could begin to trade tighter than their French counterparts on a systemic basis. However, on the other hand, this would push Italian assets to wider levels as consensus expects the Italian risk to continue to price widening at all levels (covered/senior/sub) compared to the French references.
In terms of EUR financials, and in order to keep a positive view on the sector, we will keep a close eye on the downside risks that are likely to weigh on financials: (1) the absence at this stage of a risk premium for the sector related to sovereign risks in France (risk premium is still close to the recent peak of 79-80bp); and (2) plans for windfall taxes. Our view regarding the recent decision by the Australian regulators to phase out AT1s (for local systemic banks, the 1.5% AT1 bucket will be now incorporated into the 4.5% CET1 Pillar 1 bucket, while for smaller institutions, it will be incorporated into the 2% Tier 2 bucket) is that, for now, we do not see any short-term follow-up risk, even in jurisdictions where there was previous criticism of the asset class, such as the Netherlands and UK.
France has been (and will likely continue to be) a hot topic in the EUR fixed-income market. The budget/ratings agency calendar in France will be extremely busy for the next five weeks, with key votes regarding the French budget, the repeal of Macron's pension reform and rating agencies' outlook (for now) reviews. France's net funding needs for next year are mammoth, as a 6%+ of GDP deficit needs to be financed, in addition to the QT paper that is no longer reinvested. On a more positive note, the low level of sovereign holdings in French banks (2.7% of total assets) is a powerful backdrop to avoid a more stressed situation. For a number of AMs, the 10Y OAT-Bund spread gap above 90bp is the entry point at which they would consider adding exposure to French assets.
A common talking point these days is that France's news flow has thus far had a much more noticeable impact on the rates/SSAs/covered bond front than in the credit space, where the impact has been more muted. SSAs and covered bond spreads are at multi-decade wides, while the bulk of credit spreads are at their tightest since 2021. Hence, the senior-preferred covered bond spread gap is at multi-year tights, and covered bond spreads at credit levels on an ASW basis puts the asset class on the radar of investors that historically have not looked to the latter in a long time. The jury is out on whether a potential long-tenor French covered bond would still price above the sovereign or not. Another contentious point related to this topic is whether and when the pressure on the OATs/EU/SSAs/covered bonds would begin to have an impact on the credit world (senior debt).
Risks: Last but not least, we would highlight two main risks for the next 6-12 months, beyond the obvious geopolitical factors and the US elections: 1) the French macro’s ability to withstand a prolonged period of political instability, significant social unrest and growth-unfriendly measures (higher corporate taxation, public expenditure cuts) without slipping further into a potential no-growth/recession scenario; and 2) the high negative sensitivity of yields and credit spreads resulting in a widening of the latter as inflows slowly ebb while all-in yields gradually lose their appeal as heading into a lower-yield environment could challenge two of the key supports for demand we have seen in recent years: (a) the stickiness of retail flows, as the traditional correlation seen with total returns; and (b) the popularity of Target-Date mandates (which have continued to see sizeable inflows this year).