Corporate bonds are likely to be stronger performers than government bonds in 2012, say Thibaut Cuillière, Head of Credit Strategy at Natixis, and Badr El Moutawakil, Natixis Strategist
Credit and fixed income investors should seek returns in corporate bonds in 2012 — not least because government bonds are likely to suffer from continued volatility within the eurozone. Certainly, that’s the opinion of Natixis Credit Research. In our view, Europe’s leading corporates possess distinct advantages to withstand the crisis — offering strong risk-returns in what is likely to be a challenging credit market in the year ahead.
We have based our opinion on factors such as the limited elasticity of spreads on corporate bonds relative to sovereigns, as well as corporate bonds’ strong liquidity and their consistent issuance — all making European corporate credit our choice over government bonds in 2012.
Most favoured are corporates in the industrial gas, infrastructure and consumer goods sectors, which we think will have resilience in this volatile climate. They also have a strong growth potential away from the eurozone. However, some reservations for corporate bonds as an asset class persist — not least their expensive pricing and the impact of a potential credit crunch on company finances. This means other asset classes are also worth considering most obviously in covered bonds but also, more surprisingly, in senior bank debt.
Sovereign spread volatility
European government bonds are certain to remain volatile. At the start of this year sovereign debt spreads appeared to be replicating the trend carved out by the bond markets at the end of 2011 — where volatility is sharper than that of ‘A’ rated corporate issues and is comparable with ‘BBB’ rated issues. In fact, the rise in sovereign-spread volatility has been so great it exceeds the volatility of a large number of corporates domiciled within the issuing country.
Additionally, Standard & Poor’s downgrading of nine eurozone countries — and the further warning of a one in three chance for 14 eurozone governments to be further downgraded — is likely to shape bond spread and volatility trends. Particularly with France, the fear is that the downgrade will trigger a fresh bout of spread divergence with Germany, which could have a negative impact on the corporate credit market given France’s weight as a country of origin for many issuers. However the initial reaction to the downgrades shows that they had been priced in by the markets, which could mean only a limited impact on trading flows for now. Arguably — as with the downgrading of the United States in August — S&P’s move will not undermine either the sovereign or corporate France’s access to the bond markets.
Yet the continued turmoil makes corporate bonds something of a safe-haven asset class within the eurozone. And as a safe-haven asset, 2011 proved to be a satisfactory year in terms of total return on non-financial corporate bonds. As of 2nd December, the annual yield amounted to 2.5%, which makes this asset class the most profitable among euro-denominated bond products such as sovereign, covered bonds and senior bank debt, and certainly the best on offer without the levels of volatility experienced in other asset classes.
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Indeed, if measuring an asset class’s attractiveness using a simple risk-return criterion, a preference for corporates validates recent investor behaviour, as well as the full order books for recent euro-denominated deals. Also, the strong performance of 2011 issues such as Akzo and Unibail further underlines this view.
Corporates are also strengthened by the solidity of their credit fundamentals and liquidity situation. Despite a weak macroeconomic environment, positive free cash flow is predicted in 2012 for most corporate issuers, along with a reduction in net debt and leverage ratios. Furthermore, the supply of primary paper is likely to decline again in 2012 (our research anticipates €107bn compared with €125bn in 2011) leading to an expected negative net supply of bond redemptions in 2012 for the first time since the single currency was introduced.
Of the sectors, Natixis recommends corporates in the resilient core infrastructure and industrial gases industries, as well as in the consumer goods sector due to opportunities in emerging economies. Meanwhile, the telecoms and retail sectors are likely to be more sensitive to the likely European economic contraction. We also think the automobile industry is expected to face deterioration in margins and cash flow for all issuers in the sector.
Credit crunch caution
The main counter-argument against a good performance by corporates is the likely risk of a credit crunch and any significant impact on corporate spreads, as was seen in 2008-2009. Will European corporates therefore suffer from the first emerging signs of a credit crunch? Indeed, that may be the case for small and medium-sized enterprises, where the room for manoeuvre and negotiating power lies more with their bankers than their treasurers. However, Natixis believes it is much less the case for large companies due to substantial unused credit lines and the cash cushions created since the 2008-2009 liquidity crisis, precisely to ward off any closure of the bond markets.
Of the potential alternatives to corporate bonds, covered bonds are favoured ahead of the agencies and supranationals asset classes. The former are likely to take advantage of the European Central Bank purchasing euro-denominated covered bonds as part of the Covered Bond Purchase Programme 2 (CBPP2) and the European Commission guaranteeing bank debts. Contrastingly, agencies will be negatively affected by their greater dependence on sovereign spreads, as well as their heavy issue programmes — generating a high risk of being repriced in the secondary market. Indeed, financing requirements in 2012 for agencies will be difficult to meet due to limited investor appetite for a number of supranationals in particular — as with demand for the last 10-year European Financial Stability Facility issue.
Interestingly, senior bank debt could present a surprise, having been poorly treated to the point of being reduced to a minimal weighting in the majority of diversified credit portfolios. Senior bank debt should also benefit considerably from the measures adopted by the ECB in Q4 2011 to support liquidity.
That said, bank debt spreads have a high sensitivity to the spreads of their country of domicile. And this brings us back to corporate — despite the significant handicap in appearing to be relatively expensive. Nonetheless, over the long term they should benefit from less sensitivity to sovereign spreads and from the strong liquidity of the issuer.