Attractive yields and resilient corporate fundamentals are creating compelling opportunities in euro investment grade (IG) corporate bonds. We believe our JPMorgan Funds – Euro Corporate Bond Fund, with its focus on active security selection, is well positioned to drive alpha generation in this market.
An attractive entry point to euro IG corporates
Euro IG bonds offer compelling long-term value for fixed income investors. With the European Central Bank kicking off its rate-cutting cycle in June 2024, we see high return potential of euro IG corporate bonds. Based on what markets are pricing, we could see 7-8% returns for this asset class over the next 18 months. However, while these return expectations are attractive, they are not guaranteed; the real potential lies in the ability of experienced active managers to seek alpha by capitalising on opportunities at the individual security level.
Yields remain attractive, especially now interest rates are starting to come down, with the benchmark (Bloomberg Euro Corporate Index) yield-to-worst standing at 3.43% (as of 30 August 2024), which is almost seven times higher than at the end of 2021. Market technicals are also favourable; we are seeing record inflows into European high grade funds this year, with approximately USD 13 billion equivalent of inflows in July into euro IG funds according to EPFR. This high demand is also reflected in the new issue market, where deals have typically been strongly oversubscribed. We believe attractive yield levels will continue to drive inflows for the asset class for some time.
Spreads, however, have tightened significantly and are currently trading at the lower end of their historical range, at around 120 basis points (bps). Nevertheless, we believe there is still scope for more tightening from here given corporates are underpinned by very solid fundamentals, thanks to a broadly supportive corporate earnings outlook and lower levels of corporate leverage post-Covid, which has bolstered company balance sheets.
Exploring active portfolio opportunities
Perhaps the biggest factor in favour of our active approach is our view on the dispersion across sectors with regards to the corporate earnings outlook. We anticipate average earnings across the industrials sector to begin to increase from here, which will be supportive for fundamentals moving forward. We believe we are at an inflection point for earnings in the basics, transportation and energy sectors, which have been struggling more recently, but our analysis suggests will now experience a meaningful move higher. In contrast, we anticipate autos will experience an earnings slowdown, with slower electric vehicle penetration and China demand concerns creating headwinds for the sector.
The key is to not only be selective with allocations to sectors, but also within sectors, at the individual security level. In the JPM Euro Corporate Bond Fund we have looked to achieve this by harnessing the best ideas of our 21 dedicated IG credit analysts, who have an average experience of over 21 years between them. Therefore, our credit analysts not only hold extensive knowledge of the companies that they cover, but also have experience navigating through the multiple market scenarios we’ve faced over the last two decades.
The deep proprietary research of our credit analysts has highlighted areas of the market where we think key opportunities lie. These include:
- Hybrid bonds
Hybrids are subordinated bonds of IG issuers that allow companies to issue debt, but with some equity characteristics. Hybrids are often used by companies to help fund large capex projects. To compensate for the higher risks involved, hybrids trade at two-to-three times the spread of senior debt and offer higher yields, around 4.5%-5.0%. We currently hold hybrid bonds issued by several IG companies, including Italian energy company Enel and Spanish utilities company Iberdrola. Both are issuers that we believe have solid corporate fundamentals, which allows us to be comfortable in moving down the capital structure of their debt.
- The banking sector
We like the banking sector, with European banks continuing to benefit from strong profitability. The attractive earnings of these banks is allowing them the flexibility to return capital to shareholders, and yet still retain a significant amount of CET1 above their targeted level. Commerzbank is a good example of a name that we are constructive on, with resilient net interest income, which together with the structural changes it has made in recent years, should result in more sustainable earnings for the bank going forward. We are closely monitoring the situation between UniCredit and Commerzbank, and believe the merger speculation will likely support spreads for the German bank in the near term. Given this view, we hold Commerzbank issues across the capital structure in our strategies. The name has performed well, with the Tier 2 debt being upgraded by S&P in August this year, moving from high yield to investment grade.
- Diversifying into non-euro-denominated bonds
The deep proprietary research that we are able to leverage from our global team of credit analysts enables us to evaluate credits not only at the issuer level, but also at the issue level. This allows us to capture relative value opportunities between issues of different currency denominations. For example, we hold a position in a USD-denominated bond issued by American healthcare group Baxter International. We purchased the USD-denominated issue because it was pricing cheaper than the EUR-denominated bonds on a cross-currency adjusted basis, thus offering a spread pickup over the EUR-denominated bonds. This highlights the importance of a global investment team, who are able to evaluate individual issues across both currencies and regions.
Risk exposures driven by bottom-up security selection
Our current constructive view on the euro IG corporate market is reflected in the Euro Corporate Bond Fund’s higher levels of credit risk relative to the benchmark. We are out-spreading and out-yielding the benchmark, reflecting our high conviction in the current market opportunity and our overall base case scenario of a soft landing for the economy. Over this year, we have seen a significantly higher number of ratings upgrades versus downgrades across the Euro IG Corporate Index and we expect this trend to continue into 2025, owing to the solid fundamentals of the market, creating a ripe environment for active managers to generate alpha over time.