European credit depends on the QE drip

European companies are expected to remain in reasonably sound financial health going forward. A material widening in credit spreads as result of a potential reduction in central bank purchasing is not, therefore, considered to be that likely.

Policy support including the provision of low and negative interest rates and quantitative easing (QE) has been a major prop for investment grade corporate bonds in the last few years. This has been evidenced by tightening credit spreads in general and the creation of a skew between those issuers eligible for central bank purchase and those not.
As we enter 2017, the possibility of the ending or reduction of some of this support raises its head more from a QE perspective than any likelihood of rising interest rates. Inflation in Europe is still well below the targeted level.
When QE does end, any spread widening should be reasonably limited, at least what is warranted from a bottom-up fundamental perspective, as we see corporate health being in reasonably good shape going forward.

Demand for corporate bonds will remain
A key difference between QE being used for government or corporate bonds is that the corporate bond market is a much shallower and narrower market. Consequently, the impact has been larger and has left fewer bonds available for the general market to buy.
This has left many of the corporate bond market’s traditional investors looking for new asset classes where they can pick up yield without taking on significant additional risk.
In particular, insurance companies with long-term liabilities are looking to match them with higher-yielding long-term assets.
They are looking increasingly at alternative asset classes such as private placements, loans, infrastructure funding and direct investments. The problem is that these asset classes are small compared to the corporate bond market. It is hard for investors to transfer a material amount of their assets into these markets, which means that they remain captive in the corporate bond market, thus providing on-going support for spreads.
At the same time, investors that would have historically invested in government bonds are entering the investment grade corporate bond market. With ultra-low yields in the government bond market, and bank deposits attracting negative interest rates, investors remain attracted to the investment grade corporate bond market as it is still offering a positive yield.

Corporate issuers will remain in reasonable health – though there are risks
The key credit ratios that our investment analyst team considers are free cash flow, leverage and interest cover. Over the last couple of years, leverage has increased somewhat but we forecast that it will plateau and even decline marginally in the coming years. By the same token, we expect an improvement in the profit margins for both UK and European companies. Notably, interest cover has been strong and stable, despite increasing leverage.
The cost of borrowing has fallen to the extent that companies have easily been able to service their debts. The companies that we analyse will generate enough earnings to cover interest costs by on average a comfortable 11 times.
From a sector perspective, the ‘sick man’ of the UK and European corporate grade universe was the mining sector. Faced with declining commodity prices and heightened leverage, it has endured a couple of very challenging years but through self-help produced an improvement last year. There was a material cut back in capital expenditure and the cancellation of dividends. Since then, balance sheets have been repaired, supported by a slight uptick in commodity prices. For example, Glencore has announced that it will pay a US$1 billion dividend next year and pay out 25% of profits after that.
A major current source of uncertainty is the Italian banking crisis. If it is not resolved, it risks dragging down peripheral European corporate bond markets as well as some core markets. This would start with the banks and insurers, extend to Spanish and Portuguese corporates, and then even German financials and corporates.
Geographically, the UK’s position stands out from the rest of Europe because it has the additional uncertainty of Brexit on the horizon.

Outlook
After a thorough bottom-up appraisal of the issuers that make up the European investment grade universe, we conclude that the outlook is sufficiently robust to offset the structural risk that reducing policy support affords.
Though the risks of a changing policy outlook will doubtless provide challenges in the coming year, fundamental demand for income and corporate bonds from elsewhere and mostly supportive credit metrics will mitigate most of this risk.

Jonathan Pitkanen – Head of Investment Grade Research – Columbia Threadneedle Investments