How falling rates can boost investment in European public debt

Since the great wave of inflation occurred around the world, with the United States climbing to 9.1% in terms of general CPI, the climate in many asset classes, such as European fixed income, has been quite complicated . . The economic and geopolitical storms have also added to the negative side. However, as the world moves towards 2024, there are opportunities ahead.

Eurozone inflation is already close to the European Central Bank’s target and, with the likelihood of further convergence, rates will fall in mid-2024 and into 2025. Given the eurozone’s history of low economic growth, the The consensus predicts that rates could end 2025 at 3%.

The United Kingdom is following a path of cut expectations similar to that of the EU, but with delayed disinflation at a slower pace. Thus, falling rates could be positive for European and UK government debt, and a tailwind for some segments of the credit market.

With the era of negative rates behind us, 10-year AAA-rated government bonds in euros offer positive yields of almost 3%, creating room for yields to fall and prices to rise significantly. “If economic growth disappoints or some disruption sends equity and credit markets tumbling, euro and UK sovereign bonds look poised to perform well,” AllianceBernstein experts comment in a recent report.

Hardening of the curves

The main concerns for the euro and UK government debt markets are rising fiscal deficits, leading to an oversupply of government debt and rising inflation risk premiums. “These global pressures point to a likely increase in the slope at the long end of the European Union and United Kingdom curves, where these factors tend to have the greatest impact, and where we believe investors should be underweight,” they explain from the American firm.

Currently, the EU and UK government bond yield curves are abnormally flat, and their long ends could steepen sharply as they return to more normal levels. The spread between short-term and very long-term bond yields is currently around 20 basis points in Germany and 43 basis points in the UK, compared with 12-year averages of around 105 basis points.

“We prefer British and European government bonds maturing in less than five years, which are likely to be the most sensitive to rate cuts and the least sensitive to the longer-term factors that influence long-term Treasuries,” They say from AllianceBernstein. In this context, several countries on the EU periphery have recently improved their credit ratings. Although Moody’s recent upgrade has boosted Italian public debt prices, most experts say the transalpine country has more work to do to keep pace with its peers.

“British gilts look cheap compared to German bunds, and we expect the yield gap between the two to continue to narrow… The double advantage of higher yields and some narrowing of spreads would give these spreads good results in the six to twelve months,” they predict. Thus, these experts suggest that in 2024 it will be important to focus on quality, given the foreseeable difficult economic conditions. “Weaker issuers will face greater refinancing risks, while quality issuers will likely be able to refinance maturing bonds at reasonable rates,” they state.

The sweet spot for euro credit could be the crossover zone between investment grade and high yield (high yield or speculative): BBB and BB rated bonds. Although more risk-averse investors may prefer BBBs, historically, an allocation to BBs has generated potential throughout the cycle in all but the worst default scenarios, with Euro-denominated BBs beating those by 2 %annual. And what could be bad for a higher quality euro credit allocation?

According to AllianceBernstein, for a significant drop to occur, an economic disruption would be necessary that would cause very high default rates or major difficulties in an important sector. “But now maturities are not a pressing problem, the economies are stable and, in sectoral terms, the most problematic area is real estate, which only represents 3%-4% of the high-yield market. Since this entire sector has been sold, active management can play an important role in selecting poorly valued stocks,” he highlights.