Spreads may be at record tights, but credit practitioners across the industry reckon Europe still offers the best prospect for reaping returns in 2014. Markit’s iTraxx Crossover index – the bellwether for high-yield European credit – recently hit a six-year low of 312bp, while iTraxx Main, its investment-grade equivalent, has also plumbed the depths at 77bp.
There is debate over how much further spreads can rally. But many believe a dovish ECB combined with middling eurozone growth predictions represent the best opportunities for credit investors next year.
“Everyone is underweight Europe, especially US investors. We see a low growth scenario compared with the US and UK, which should make European credit a great place for money to hide,” said Gennaro Pucci, founder and CIO at PVE Capital, a credit hedge fund.
The blossoming US economy – reinforced by solid non-farm payroll data on Friday – has led some analysts to take bearish views on the country’s credit markets for 2014, as the US Federal Reserve is expected to scale back its bond purchases, causing rates to rise.
“There is a sweet spot in Europe that will continue for a while, with no fear of a rates increase from the ECB. Looking at the rate component, credit spreads are wider in Europe compared with the US. And we are still a long way off the tights in Main and Crossover we saw in late 2006,” said Derrick Herndon, portfolio manager at PVE Capital.
The spread between iTraxx Main and CDX has shrunk threefold since April, but the European IG benchmark still remains 11bp wider than its US counterpart, suggesting there is further value to be extracted.
“There’s increasing evidence the credit cycle is turning in the US, which we don’t see in Europe. Our prediction of European returns of 1% for 2014 may not sound appealing, but it is versus the US,” said Stephen Dulake, European head of credit strategist at JP Morgan.
The spectre of the Fed tapering hanging over the markets has previously spooked investors. Ten-year US Treasury yields rocketing to 3% in early September – almost double their May levels – created ripple effects through financial markets. Main and Crossover hit year-wides of 132bp and 529bp respectively in mid-June.
The ECB’s determination to anchor short-term interest rates has provided some comfort to European investors, though. Moreover, some believe there is no need to fear European credit capitulating in the face of rising sovereign yields on the other side of the Atlantic.
After all, Main’s all-time tight of 20bp in June 2007 occurred in a very different interest rate environment. Five-year Treasury yields were around 5%, while the German five-year Bobl was at 4.4%.
“Credit returns have both a credit and a rates component. What looks out of place right now is the rates component, which is very low,” said Peter Duenas-Brckovich, EMEA head of flow credit trading at Nomura. “Credit spreads could tighten even if rates rise, especially if the latter is due to strong economic growth.”
Hedge funds remain hopeful the ECB’s Asset Quality Review will encourage European banks to further mend balance sheets and shed non-performing loans, offering investors juicy yields. Arbitrage and carry opportunities in credit derivatives markets also offer value for investors.
“While bond returns were low in 2013, there were a lot of opportunities in the CDS space, and that will continue to be the case in 2014. Credit spreads over-compensate for default risk. We suggest generating P&L by stripping out that component, whether it is through basis trades or carry trades,” said Saul Doctor, credit derivatives strategist at JP Morgan.
Selling credit options has proved to be a popular carry trade through 2013, while other investors have turned to the index tranche market to take more nuanced views to earn pick-up.
More generally, many see the facelift that European capital markets are undergoing, where bank balance sheets are shrinking and corporates are increasingly tapping investors directly, as a long-term boon for credit.
“Banks continue to be disintermediated by the growing European capital markets, which is a huge and positive development. Historically, Europe has had underdeveloped capital markets compared with the US and the fact that this is changing is bullish for the structure of the markets,” said Duenas-Brckovich.
IFR 2013 7 December to 13 December 2013 | By Christopher Whittall