Latecomers to Europe's Credit Rally May Struggle for Gains

(Bloomberg) -- Europe’s credit market rally has proved tempting for investors looking to add risk this year amid a wider sag in yields as the euro-area economy sputters. But latecomers to the action should be warned that further gains may be limited.

Andrew Jackson, who helps oversee 33.5 billion pounds ($43.6 billion) as head of fixed income at Hermes Investment Management, has started cutting credit risk after buying assets cheaply in December and riding the rally.

“If you’re long the market at the moment, you’re really only long the rubbish. The good stuff can’t get tighter,’’ he said. “The market was irrationally bearish in December and is becoming irrationally exuberant now.’’

Euro high-grade credit spreads have narrowed more than 40 basis points this year to 110 basis points, the lowest in eight months, Bloomberg Barclays index data show. But that’s against the backdrop of a slowing euro-area economy, with German manufacturing data released on Thursday showing an ongoing slump.

The cautious economic picture seems set to further dampen European Central Bank hopes of a quick recovery after it cut its 2019 euro-area growth forecast to 1.1 percent in March. As it stands, even that is starting to look optimistic.

In contrast, European credit is enjoying its best start to a year since 2012. Investment-grade euro corporate bonds yield just 0.81 percent, down from 1.4 percent near the start of the year, while protection against junk bond defaults is the cheapest in more than a year, according to data compiled by Bloomberg.

“We wouldn’t bet on further spread tightening,’’ said Peter Kaufmann, a corporate bond analyst at Erste Bank. Kaufmann said markets have already taken into account the potential for resolution in trade talks between the U.S. and China while Brexit has not made any significant impact. “Pricing-wise, we’re quite toppish.’’

Latecomers to Europe's Credit Rally May Struggle for Gains

Corporate bonds have benefited from central banks’ dovish turn as investors have poured cash in to credit funds in recent weeks. Both investment-grade and high-yield funds recorded more than $1 billion of inflows in the week through April 17, according to Jefferies analysts, who cited EPFR data. The fresh cash has helped offset any concerns about the weakening macroeconomic backdrop and its positive effect on credit could continue a little longer.

“Inflows into euro credit are likely to continue pushing spreads tighter in absence of convincing alternatives for euro-based fixed income investors,” Commerzbank AG credit strategists Marco Stoeckle and Cem Keltek wrote in a note to clients on Thursday.

For those wanting a piece of the credit market’s gains, there’s a temptation to layer on more risk in order to catch up. Hermes’ Jackson warns this is a risky strategy. “We’re setting ourselves up for more volatility. The longer this goes on, the more leverage we get in the system," he said.

©2019 Bloomberg L.P.