Euro Investment-Grade (IG) Corporate Bond Views—Q1 2021

    Franklin Templeton Fixed Income

    After improving in the third quarter of 2020, euro IG corporate fundamentals are expected to deteriorate due to new social restrictions across Europe. Although companies are better prepared and the rules are less restrictive than they were in the spring, earnings recovery will be further delayed. Additionally, news of an effective COVID-19 vaccine is encouraging; however, uncertainties remain on the logistics of rollout and timeline, and renewed or rolling lockdowns cannot be ruled out in the first half of 2021. Against this backdrop of uncertainty, we expect European corporates to remain conservative and focus on deleveraging over the next year, by further cutting costs to protect margins, limiting investments, selling assets or raising equity, whilst maintaining strong liquidity positions.

    Some sectors, such as utilities, consumer non-cyclicals and telecoms, have done well this crisis, and merger and acquisition activity has recently picked up in these sectors, but the impact on credit metrics has been rather limited. Dividends could be resumed, but payouts are expected to be lower than pre-crisis. Liquidity positions are robust in general, with financial needs over the next 18 to 24 months covered after record issuance in the first half of this year. Most large euro corporates have successfully managed their debt profile by extending their debt maturity profile and reducing the cost of debt. Some corporates have tendered their bonds thanks to proceeds from asset disposals. As euro IG credits are in general well-funded, even sometimes overfunded, supply is expected to decline next year. Liability management exercises have been numerous, including in the corporate hybrid arena, and this should continue in 2021.

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    Fiscal and monetary policies remain supportive. With the open-ended European Central Bank’s (ECB’s) Corporate Securities Purchase Programme and, to a lesser extent, the Pandemic Emergency Purchase Plan, the ECB’s support has been strong in 2020 and will continue in 2021. Based on our estimates, the ECB’s monthly corporate bond purchases have amounted to around €10 billion on average, though we would not be surprised if monthly purchases declined slightly in 2021. Governments have extended support measures until at least March 2021, and the ECB should announce new monetary measures in December. The main risk for the euro IG market would be a taper or a halt of corporate bond purchases, but we believe it is very unlikely in the foreseeable future.

    European banks have weathered the COVID-19 pandemic well so far, as banks entered the crisis with generally strong balance sheets and have benefited from the government’s large fiscal and liquidity support packages as well as the regulatory flexibility shown by the regulators. Unlike in 2008-09, there has not been a credit crunch, as the government-guaranteed funding programs and the generous targeted longer-term refinancing operations provisions have allowed credit to continue to flow to the real economy, which along with the repayment moratoria, have limited near-term liquidity-induced defaults and allowed banks time to gradually build up loan loss provisions to minimize the impact to their balance sheets. However, despite strong balance sheets, profitability is weak. At the end of 2019, banks reported an average return on equity (ROE) of approximately 6%, with almost half of banks failing to cover their cost of capital. This year, loan impairments have increased roughly three times year-over-year, which has pushed down the average return on equity in the first half of 2020 to only 0.5%. We are toward the end of the third-quarter earnings season, which has been better than expected. Most banks have beaten consensus, mainly because of lower-than-expected loan impairments. Capital positions have continued to edge higher and there has not yet been any material deterioration in headline asset- quality metrics.

    Overall, we expect bank fundamentals to gradually deteriorate going forward, but we believe that banks, in general, are well-prepared for the expected fallout. Despite their weak profitability, we believe loan impairments should be largely absorbed through profit and loss statements, and the government guarantee scheme should help moderate risk-weighted asset inflation.

    The euro IG sector is not immune to the environment in the United States, as US corporates account for slightly below 20% of the Bloomberg Barclays Euro Corporate Bond Index1; however, the impact from the US election outcome and the potential actions of a Biden administration is expected to be limited.

    In our view, the ECB’s demand for IG corporate bonds paired with a decline in euro IG supply will be supportive for the sector. The euro IG asset class remains attractive, in our view, although low yields could become an issue for the sector. Euro IG spreads have almost retraced to the level at the end of 2019, and yields are not far from their all-time lows. Although these rather expensive valuations should limit upside, we foresee potential spread compression in some parts of the market. Despite current valuations, we remain slightly optimistic due to deleveraging prospects and continued strong technicals. Over the next 12 months, we maintain our neutral with reasons for optimism outlook.

    ENDNOTES

    1. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.


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