This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 20 - June 26, 2016.

European corporate bonds are expected to outperform in the next 12 months because of their strong fundamentals. This is despite the possibility of a “Brexit”, or the UK leaving the European Union.

Eric Brard, global head of fixed income at Amundi Asset Management, says European corporate bonds have been deleveraging in the past few years while the EU’s economy is in recovery. This compares with companies in the US, where the leverage ratio is higher and corporate earnings have peaked and are expected to decline.

“European corporate [bonds] remain attractive because the fundamental conditions are positive for the asset class. European corporates have been in a deleveraging cycle. For instance, if you look at the debt-to-Ebitda [earnings before interest, taxes, depreciation and amortisation] ratio in the investment grade space, European corporates have a ratio of about one to four, which is two times lower than in the US,” he adds.

“We expect the EU’s recovery to continue, [albeit] at a slow pace. Our forecast for real gross domestic product (GDP) growth in the eurozone is 1.5% for this year and 1.4% for 2017.” 

Amundi Asset Management is one of the largest asset management firms in Europe, with €1 trillion (RM4.6 trillion) under management, half of which is invested in global fixed income.

The EU economy had a slow recovery last year, with its GDP growing at 1.5% compared with the US economy’s 2.4%. But in the first quarter of this year, the EU economy grew 0.6%, outpacing the US at 0.5% and beating economist expectations of about 0.4%.

Brard says European corporates have easier access to funding and their yields are back at pre-global financial crisis levels of about 1% for investment-grade bonds and about 3% for high-yield bonds. Although lower than the 2.5% and 6% yields provided by their US counterparts respectively, European corporate bonds have healthy fundamentals, he adds. 

Brard expects continuous capital inflows into the European corporate bond space following the European Central Bank’s asset purchases this month, which will include investment-grade euro-dominated bonds, as well as from Asian investors seeking diversification. 

Brard is not underweight European corporate bonds in general even though the Brexit referendum is just around the corner. He says the asset class remains attractive despite the asset management firm reducing its holdings of corporate bonds in the UK financial sector. 

“One of the major risks to be hedged is our holdings in the British financial sector [corporate bonds]. We have reduced a little of our position as the event will put some pressure on it,” he explains. 

Europe, emerging markets to benefit from stable oil prices and gradual interest rate hikes

Amundi is also looking at emerging market sovereign bonds, which are expected to benefit from global economic trends. Brard says the firm has started to allocate more investments in Russia and Brazil, where valuations are relatively low, owing to the global economic slowdown and plunging oil prices in the last two years. These markets, once shunned by investors, are becoming attractive as their macroeconomic conditions improve.

Brard says stable commodity prices, especially crude oil, will benefit these markets. As at June 15, Brent crude oil had recovered to US$49.12 a barrel from a low of US$29 a barrel at the beginning of the year. 

Oil prices have remained relatively stable in the US$40 to US$50 range since April despite news that the Organisation of the Petroleum Exporting Countries’ (OPEC) meeting on April 17 ended without an agreement on freezing oil production. Thus, oil exporting countries such as Russia and Brazil are expected to benefit from this trend. 

“Russia went through quite a deep recession as it is very sensitive to oil prices. It is now benefiting from the oil price stability. Russia’s sovereign bond valuations have been low so far,” says Brard.

Meanwhile, he expects the Federal Reserve’s interest rate hikes to be gradual this year as the US economy’s recovery has slowed and inflation has remained below 2%. Emerging markets will be the beneficiaries of such moves as their currencies will not face further weakness against the US dollar. 

“The US economy’s improvement is quite satisfying, looking at the numbers such as the unemployment rate. We have seen this recovery for quite a while now. What we expect next is a slight slowdown. The economic situation has only been possible with the Fed’s actions [of adopting a dovish stance],” says Brard.

“The Fed is expected to be cautious. While we have begun to see an increase in inflation figures, it is not a strong one. The recovery cycle is maturing and it [the US economy] remains fragile. Our scenario is that there may be one or two interest rate hikes, but it will be a long time before we get back to a much higher rate.” 

Accommodative monetary policy in other parts of the world such as Europe, Japan and China will provide ample liquidity in emerging market bonds, says Brard. Thus, Amundi will look at reallocating more of its investments into emerging market local currency sovereign bonds.

Brard says some emerging market currencies will see less weakness in the near future as the central banks of major economies are expected to be cautious when it comes to raising interest rates. “We favour more local currency investments [in the emerging market space] at the moment. This means we are getting more foreign currency risk in our portfolio.”

Inflation-linked bonds is another space he is looking at. These securities, also known as inflation-indexed bonds, are mainly issued by governments and are designed to protect investors from inflation. 

The value of these bonds are tied to the cost of consumer goods such as the consumer price index or other indices in different countries. When inflation rises, the value of inflation-linked bonds follow suit and vice versa. However, these bonds tend to underperform during a deflation, when interest rates are low.

Brard says inflation-linked bonds are quite a contrarian call at this stage, but inflation could pick up as commodity prices recover and there could be an unexpected wage push inflation in the US.

“We know that the recovery in commodity prices, oil in particular, is going to make headline inflation more visible … This trade is quite contrarian at this stage, but it is a hedge against the risk of a sudden adjustment of inflation expectation going forward. This adjustment could also be the result of unexpected tensions surrounding wage inflation in the US,” he adds. 

Brard says the low growth and low interest rate environment is expected to continue this year as the global economy faces structural and cyclical headwinds such as an ageing population, slower technology progression leading to lower productivity and weaker global growth.

At the same time, central banks have implemented negative interest rate policies to fight deflation. This will see capital flow into higher yield investments such as corporate bonds. Thus, the yield spreads between sovereign and corporate bonds are expected to tighten in the future.

The risk of volatility is low, unless there are unexpected announcements by central banks and there is a reaction from market participants, says Brard. “The current situation does not favour higher volatility as there will be pressure on interest rates. However, volatility will increase if there are any unexpected turnarounds in monetary policy such as an unexpected increase in US rates, owing to any kind of reversal in its economy.” 

Reducing risks in the event of Brexit

The Brexit referendum, to held on June 23, will see UK citizens vote on whether to remain in the European Union. In anticipation of this, Amundi Asset Management has reduced some of its position in pound-dominated corporate bonds, mainly issued by UK banks, and sovereign bonds of some of the peripheral countries in the EU, says its global head of fixed income Eric Brard.

“We are reducing a little of our position in the UK financial sector, which are corporate bonds issued by banks. We have also reduced a little of our position in the sovereign bonds of some of the peripheral countries in the EU. This will allow us to hedge any potential volatility associated with Brexit and provide us with some reserve to reinvest in the [European] market at the right time,” he adds. 

“More uncertainty and volatility mean increased risk premiums, and [the situation will create] a preference for assets that are supposed to be safe. Thus, we can expect some spread widening within the euro sovereign and corporate bond space.

“We are looking more on the positive side of things and aim to benefit from the resulting market conditions such as wider yield spreads caused by Brexit or market volatility surrounding the referendum.”

A Brexit could also create instability in the EU as it is expected to cause the spread of sovereign bonds in the peripheral countries and Germany (which is seen as a safe haven by investors) to widen before and after the referendum, says Brard. Thus, the firm has reduced its holdings in some of the sovereign bonds of the peripheral countries expected to be impacted by the event such as Italy, Hungary, Romania and Croatia.

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