Are investors being paid to take risk within credit?

August 1, 2024

If you have any feedback on this article or are interested in subscribing to our content, please contact us at opinions@muzinich.com or fill out the form on the right hand side of this page.

--------

In his latest column on key developments, themes and opportunities in credit markets, Ian Horn explores what is happening to spread premia in the European investment-grade market.

Many companies reported second quarter earnings in July. Although the results have been mixed, so far, we have seen fewer positive surprises than in any quarter since the height of the COVID-19 pandemic.¹

In an environment of political uncertainty and signs of macroeconomic weakness, it is timely to again consider one of the key questions for investors: are they being paid to take risk within credit?

This is not a question of whether spreads are attractive at current levels, but whether within corporate credit specifically — European investment grade (IG) — investors are being adequately compensated to take additional risk of varying forms.

This has been a frequent topic of conversation with clients throughout 2024. In response, we have argued investors now need to be more discerning about where they take risk relative to the last 2 years, and that fundamental research will become even more important.

The spread rally seen since the middle of 2022 has compressed many traditional sources of additional credit spread. Whilst we have not concluded there is a need to immediately reduce risk in our portfolios, we do believe an ‘up-in-quality’ bias makes sense over the coming months.

Quantifying spread premia

To quantify where spread premia are versus historic levels, we have constructed an internal reference index² for European IG using 5 simple inputs – ratings, sector, curve, subordination and peripheral versus core.

Based on our opinion and analysis, we have focused on traditional sources of risk in the market. We believe these 5 factors (credit risk, subordination risk, interest rate risk, geographic risk, and sector risk) are the key risks for which investors would typically expect a spread premium.

Figure 1: A spread premia index for European IG

Note: The spread premia indicator calculated here is based on the spread-to-worst versus government bonds provided by the ICE BofA Platform for the indices listed below.

Source: ICE BofA Platform and Muzinich analysis, monthly data, as of June 30, 2024. For illustrative purposes only, not to be construed as investment advice.

As shown, spread premia are close to their historic lows, although not in uncharted territory. Reaching these levels of spread premia has not historically prompted a sudden reversal and a decompression of spreads. We can — as seen in 2017 and 2021 — remain at these compressed levels for some time.

It is also possible credit spreads at a broader level can continue to tighten. However, the potential additional return from spread tightening in higher beta parts of the market would appear to be limited if history is any guide.

Over the coming months, we plan to provide our clients with regular updates on spread premia trends in European IG and other credit markets.

Our methodology: Index inputs

1. Ratings: Additional spread for credit quality - the spread difference between BBB and single-A rated instruments.
2. Sectors: Additional spread for issuer cyclicality - the spread difference between a selection of traditionally cyclical and non-cyclical sectors.
3. Curve: Additional spread for duration risk - the spread difference between longer-dated and shorter-dated bonds.
4. Subordination: Additional spread for subordination - the spread difference between subordinated and senior instruments from financial issuers.
5. Peripheral versus core: Additional spread for perceived geographic risk - the spread difference between instruments from peripheral and core European issuers.

References

1.Bloomberg, ‘S&P 500 Index Positive Surprises,’ as of July 29, 2024
2.Calculated internally using Muzinich analysis; this is not to be construed as advice.

 

This methodology was created by Muzinich to achieve the aforementioned objective of measuring spread premia in the European investment-grade market governed by this methodology document. Any changes to or deviations from this methodology are made in the sole judgment and discretion of Muzinich & Co.

--------

Index descriptions

The index presented here combines multiple indices from the ICE BofA Platform, listed below.

ER30 - The ICE BofAML Single-A Euro Corporate Index is a subset of the ICE BofAML Euro Corporate Index including all securities rated A1 through A3, inclusive.

ER40 – The ICE BofA ML BBB Euro Corporate Index is a subset of the ICE BofA ML Euro Corporate Index (ER00) including all securities rated BBB1 through BBB3, inclusive.

EJAU – The ICE BofA Euro Auto Group Index is a subset of ICE BofA Euro Corporate Index including all securities of Automaker, Auto Loan and Auto Parts & Equipment issuers.

EJRL – The ICE BofA Euro Retail Index is a subset of ICE BofA Euro Corporate Index including all securities of sector level 3 Retail issuers.

EJLE – The ICE BofA Euro Leisure Index is a subset of ICE BofA Euro Corporate Index including all securities of Leisure issuers. EJEN – The ICE BofA Euro Energy Index is a subset of ICE BofA Euro Corporate Index including all securities of Energy issuers.

EK00 – The ICE BofA Euro Utility Index is a subset of ICE BofA Euro Corporate Index including all securities of Utility issuers.

EJCS – The ICE BofA Euro Consumer Goods Index is a subset of ICE BofA Euro Corporate Index including only sector level 3 Consumer Goods securities.

EJHC – The ICE BofA Euro Healthcare Index is a subset of ICE BofA Euro Corporate Index including all securities of healthcare issuers.

EJTC - ICE BofA Euro Telecommunications Index is a subset of ICE BofA Euro Corporate Index including all securities of Telecommunications issuers.

ER01 – The ICE BofA ML 1-3 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index (ER00) including all securities with a remaining term to maturity less than 3 years.

ER0V – The 1-5 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 1 years and less than 5 years.

ER06 – The ICE BofA 5-10 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 10 years.

ER09 – The ICE BofA 10+ Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

EBXS – The ICE BofA Unsubordinated Euro Financial Index is a subset of ICE BofA Euro Financial Index excluding all subordinated securities.

EBSL – The ICE BofA Euro Financial Subordinated & Lower Tier-2 Index is a subset of ICE BofA Euro Financial Index including all subordinated and tier 2 securities.

EBCB – The ICE BofA Euro Non-Periphery Financial Index is a subset of ICE BofA Euro Financial Index excluding all securities with Greece, Ireland, Italy, Portugal and Spain as the country of risk.

EBCA – The ICE BofA Euro Periphery Financial Index is a subset of ICE BofA Euro Financial Index including all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

ENCD – The ICE BofA Euro Non-Periphery Non-Financial Index is a subset of ICE BofA Euro Non-Financial Index excluding all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

ENCC – The ICE BofA Euro Periphery Non-Financial Index is a subset of ICE BofA Euro Non-Financial Index including all securities with a country of risk equal to Spain, Italy, Portugal, Ireland and Greece.

Important information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of future activities and future performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-07-30-14165