European credit: seeking to make the most of the new market regime

In 2022, investors faced a very different market backdrop to that experienced during much of the previous decade. In an effort to rein in significant inflationary pressure, central banks implemented an enormous shift in monetary policy, moving from net buyers to net sellers of assets. Amid the resulting spike in interest-rate volatility, European investment-grade yields reached levels not seen for more than 10 years.

In our view, this new market regime creates potentially compelling opportunities for active credit managers through a combined focus on security selection and, increasingly, sustainability.

Why is today’s environment creating opportunities in Europe?

While economic growth slowed globally in 2022, Europe has been at the epicentre given the Russia/Ukraine war and the ensuing energy crisis. Option-adjusted spreads on European investment-grade credit, as measured by the Bloomberg Barclays Euro Aggregate Corporate Index, now rank in the 90th percentile relative to history (Figure 1), while the yield to worst for the Index moved from close to zero at the start of 2022 to more than 4% as of the end of the year. In our view, the risks relating to the Russia/Ukraine war and the energy crisis have largely been factored into market pricing, and some higher-quality issuers now trade at very favourable prices.

Figure 1

A growing focus on ESG considerations

We believe ESG factors can have a significant impact on long-term company performance, particularly as the dispersion among investment-grade issuers increases. Growing ESG-related risks in areas such as climate change or supply-chain issues together with quickly evolving European regulations create further impetus for well-performing companies to progress their sustainability practices. This accelerating momentum has only increased the importance of identifying likely ESG “winners” and “losers”. In practice, we think careful consideration of ESG factors is now on a par with fundamental credit analysis in identifying risks and opportunities at both a sector and company level.

In parallel, we think engaging with companies to promote positive change is essential to effectively incorporate ESG criteria into the investment process. In our opinion, this is particularly important in the context of climate risk given the likely material impact on company fundamentals of high carbon emissions and climate transition risks.

By actively engaging with high-carbon-emitting companies, investors can get a much better handle on companies’ willingness and ability to transition towards more sustainable activities. Robust dialogue and the sharing of insights can encourage companies to accelerate their plans. In turn, this can help investors decarbonise their portfolios and contribute to progress within the wider investment universe.

Taking an active approach is key in this new regime

This new, more volatile market regime has reaffirmed our fundamental belief that credit is a cyclical asset class and that understanding macro and political risk is crucial for anticipating changes in the economic cycle. In our view, such a lens is particularly important in the European credit market given the varying political regimes across the region. The continued removal of accommodative policy by central banks will accentuate those idiosyncratic risks at a time when companies are increasingly exhibiting late-cycle behaviour. We think that such an environment calls for an active approach that combines top-down macro insights with bottom-up, fundamental research that spans a broad range of perspectives, notably regional expertise and ESG research.

Bottom line on European credit markets

This year, we expect the growing importance of ESG factors and the rising dispersion in corporate fundamentals to create attractive opportunities in the European investment-grade market for investors who can pair credible ESG processes with top-down insights and bottom-up credit research.