09 Mars 2016

The beginning of 2016 has proven to be one of the most volatile starts of the year in the recent history of financial markets. European credit was no exception of that trend: around the middle of February, European HY was down ca. 4% YTD, the iTraxx Xover index reached 500bps and the AT1 bond market fell as much as 15% YTD. Such volatility comes on the back of a poor second half of 2015, which makes us deeply concerned that financial conditions have now tightened significantly enough to derail the current credit cycle. The second half of the month saw spreads retracing a large part of their earlier losses as investors’ risk appetite improved on the back of supportive statements by various policymakers (US, EZ, UK, China) and of some stabilization in energy prices. However, we still think that there is a more-than-50% probability to see European credit fundamentals deteriorate and credit assets deliver negative returns in 2016. Not only do we see rising risks from every angle we look at the world, but we also believe that European credit markets are today more vulnerable to such risks than at any time since 2009.


Things will get worse or better. But they will not stay the same.

Against this backdrop, one scenario for 2016 would see the various risk factors surrounding European credit – China, EM, commodities, DM growth, financial conditions, to name a few – getting increasingly real, visible and impactful. As a result, the deterioration of European credit fundamentals – especially for some leveraged segment of the HY market – would start accelerating, whereas investor risk aversion would rise to crisis levels. In such a scenario, the recent repricing of European credit wider/lower will provide little buffer to protect invested capital against the resulting selloff. Although European spreads currently trade close to recessionary levels, we believe that should the credit cycle turn in 2016, credit spreads will trade significantly wider/lower than where they currently do.

Another scenario could also see the above-mentioned risks abating or not materializing in synch, defaults being broadly limited to HY energy, metals and mining credits, and large capital flows coming back to the asset class. Such a scenario would likely loosen financial conditions and restore a greater investors’ risk appetite. Importantly, in the ZIRP world we are living in today, current credit spreads and yields would look attractive again in the context of improving fundamentals.

We are not absolutely certain which of the two scenarios will play out in 2016, but we are quite confident of the consequences which either scenario would have for European credit markets. That’s why we believe that the current valuations of European credit markets are unlikely to stay where they are: they will either crack or come back to where they were a year ago.


Play defense and keep some dry powder

The direct implication of our view in terms of portfolio positioning was to reduce the fund’s directionality and focus on capital protection. Specifically, our HY exposure is now mainly concentrated on relatively short-dated instruments, catalyst-driven stories or deeply-discounted bonds with sizeable hedges. In IG, we maintain our short bias via single-name positions in sectors which do not price the risk of a broader credit crunch and of structural credit deterioration. With regards to financials, we believe that the sector credit quality is stronger than it has ever been. At the same time, we acknowledge that no bank credit profile would be immune from the shocks of a credit crunch, which may well put bank creditors at much greater risk in the post-GFC regulatory environment than in previous credit crises. However, after the recent repricing – in the AT1 market in particular – we now see a select number of attractive long positions where valuations offer a significant buffer against sector-wide negative headlines. Overall, we are positioned to have the flexibility to take advantage of a potentially sizeable market dislocation should it occur in the next few months.


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