Close Up: Is the compression trend going into reverse?

October 3, 2024

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In his latest column on the key developments, themes and opportunities in credit markets, Ian Horn examines the recent decompression in European credit spreads.

Earlier this year, we commented on how spread premia had become compressed, supporting an ‘up-in-quality’ bias in credit portfolios. Our view was that whilst credit spreads still offered value in some markets – particularly short-dated credit – the additional spread premia available for incremental risk was historically compressed.

We discussed this with reference to a proprietary spread premia indicator for European investment grade, which showed traditional spread premia for various risks (including ratings, duration, subordination, geography and cyclicality) were historically compressed.

Since June, we have seen European credit markets show signs of decompression, or at least fatigue in the compression trend that began in late 2023. In investment grade, this can be seen in the spread pick-up between BBB and single-A rated credit. This has stabilised in recent months and is now showing signs of widening. An even clearer trend has been visible between BB and BBB-rated credit.

We believe this is the result of four confluent factors:

• European primary markets re-opening in mid-August bringing healthy supply;
• Cyclical concerns after weak Q2 earnings and market-wide profit warnings;
• Profit taking after strong recent performance and a lack of willingness to add risk ahead of the US elections;
• Less demand for credit from ‘yield buyers’ due to lower yields since June.

Figure 1: Spread premia by rating in European credit

Past performance is not a reliable indicator of current or future results.

Source: ICE Data Platform, as of September 27, 2024. ICE BofA BBB Euro Corporate Index (ER40), ICE BofA Single-A Euro Corporate Index (ER30), ICE BofA ML BB Euro High Yield Index (HE10). Please see index descriptions for full index names. Indices selected represent best proxy to show divergence between A-rated credit spreads, BBB spreads and BB spreads. Index performance is for illustrative purposes only. You cannot invest directly in an index, which also does not take into account trading commissions or costs. Additionally, indices do not include reinvestment of dividends and the volatility of indices may be materially different over time.

Decompression has also been visible in certain cyclical sectors versus more defensive ones. In particular, the auto sector has decompressed relative to the broader market on the back of high-profile profit warnings and weakening investor sentiment.

Figure 2: EUR spread premium in auto sector versus broad non-financial IG

Past performance is not a reliable indicator of current or future results.

Source: ICE Data Platform, as of September 27, 2024. ICE BofA Euro Auto Group Index (EJAU), ICE BofA Euro Non-Financial Index (EN00). Please see index descriptions for full index names. Indices selected represent best proxy to show divergence between auto credit spreads from broader IG market. Index performance is for illustrative purposes only. You cannot invest directly in an index, which also does not take into account trading commissions or costs. Additionally, indices do not include reinvestment of dividends and the volatility of indices may be materially different over time.

In Figure 3, we have updated our spread premia indicator for European investment grade, which illustrates how broad spread premia have stabilised at historically low levels. We believe we are now seeing the start of a decompression phase that could continue until the US elections and Q3 reporting period.

The outcome of the US elections is unlikely to provide immediate relief from political and fiscal uncertainty; however, Q3 earnings could – importantly – confirm whether the weakness in Q2 has continued.

Figure 3: European investment grade spread premia indicator

Past performance is not a reliable indicator of current or future results.

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

Source: ICE BofA Platform and Muzinich analysis, monthly data, as of September 27, 2024. For illustrative purposes only, not to be construed as investment advice.

With so much focus on rates and central banks, we believe many investors may have missed this shift in momentum. In our view, strong total returns in European investment grade since June have also masked the weaker tone in spreads.

The Fed’s 50 basis points rate cut appears to have confirmed the existence of the ‘Fed put’ and willingness of the US central bank to act in a meaningful way should weaker economic data materialise. With this in mind, we believe the probability of a soft landing across developed markets has increased.

This recent decompression theme could continue ahead of the US election and Q3 earnings. While we believe it is too early to call a ‘buy-the-dip’ moment on spreads, in the absence of a meaningful deterioration in corporate earnings, a return of attractive spread premia could be an opportunity to add credit risk to portfolios.

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This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of September 30, 2024, and may change without notice.

Our methodology for Figure 3: Index inputs

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.

Ratings: Additional spread for credit quality - the spread difference between BBB and single-A rated instruments.

Sectors: Additional spread for issuer cyclicality - the spread difference between a selection of traditionally cyclical and non-cyclical sectors.

Curve: Additional spread for duration risk - the spread difference between longer-dated and shorter-dated bonds.

Subordination: Additional spread for subordination - the spread difference between subordinated and senior instruments from financial issuers.

Peripheral versus core: Additional spread for perceived geographic risk - the spread difference between instruments from peripheral and core European issuers.

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

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.

HE10 – The ICE BofA ML BB Euro High Yield Index is a subset of the ICE BofA ML Euro High Yield Index (HE00) including all securities rated BB1 through BB3, 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.

EN00 - EN00 - ICE BofA Euro Non-Financial Index tracks the performance of non-financial EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets.

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.

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.

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