Why investors still need European credit

By Tobias Stein

The introduction of the euro in 1999 within the EMU countries was the origin of the European credit market. Over the last 20 years, the market has grown considerably – early and expected domination by European issuers from EMU core countries has evolved into a market featuring global issuers from developed and emerging markets. Nowadays, the share of investmentgrade issuers outside the eurozone represents more than 40% and has been steadily growing despite frequent doubts about the survival of the common currency, especially in the aftermath of the euro crisis in 2011. Multi-national issuers especially have embraced the market as a diversifying source of funding, taking full advantage of the ultra-low yield environment. Whereas the number of outstanding issues has tripled over the last 20 years, average duration has been relatively stable (in contrast to the European sovereign bond market, where a noticeable duration extension has taken place), which forms a good basis for empirical analysis. For an investor faced with the current capital market environment, the question is whether an allocation to this market segment still makes sense. Specifically, is the risk-return profile replicable with a combination of sovereign debt and equity investments, or does credit deliver some additional benefit?

Measured with a standard market index, since 1999 an investor in investment grade European credit has achieved about 2.5% excess return per annum versus the money-market, with an annualised volatility of about 3.3%. Pure credit-excess return was about 0.8%; the remaining 1.7% represents the realised term premium of duration-matched German sovereign bonds (Bunds). During the same period European equities yielded an excess return of about 3.7%, but of course exhibited significantly higher volatility of about 15%. Thus the risk-adjusted returns were historically far more favourable for corporate bonds.

At the height of the euro crisis in July 2012, ECB president Mario Draghi’s famous speech to do ‘whatever it takes to preserve the euro’ marked a significant turning point for risk markets. Since then, volatility of the different risk premia has declined between 20% and 30% (see Figure 1). While the realised term premium was the same compared to the full sample result, credit-excess and

equity-excess returns were significantly higher: once again, credit delivered by far the best risk-adjusted return (4.1% annualised return, with realised volatility of 2.6% per annum).

Since the correlation between equity excess and sovereign excess returns has been significantly negative over the entire period since 1999, considerable improvement in the risk-profile has been available from a combination. A mixed portfolio - with 40% European equities and 60% German Bunds - matches the historical return from European investment grade credit, but with a higher volatility of about 5.6%. Another asset class blend, consisting of 20% European equities and 80% sovereign bonds, resulted in a similar volatility compared to credit but lagged the historical returns by about 40 basis points per annum.

Results for the period since July 2012 are similar: despite the level of realised returns being markedly higher, the riskadjusted returns remain even better for European credit. Correlation between term premium and credit-excess returns is stable and has remained negative for the last seven years. In contrast, the pattern for equity-excess returns and the term premium has changed to become more neutral since 2012, leading to a partial loss of diversification benefits. The realised return per unit of risk within a European credit investment has been about 1.5, whereas the premium in a blend of sovereign and equities has been

5,0%

4,0%

3,0%

2,0%

1,0% 2,0%

Credit

3,0%

90/10 Sov/EQ 4,0%

5,0%

80/20 Sov/EQ 70/30 Sov/EQ 6,0%

60/40 Sov/EQ

Source: MSCI, ICE BofAML, Quoniam. The index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its Third Party Suppliers and has been licensed for use by Quoniam Asset Management GmbH. ICE Data and its Third Party Suppliers accept no liability in connection with its use.

in the area of 1.0. Thus the difference in risk-adjusted returns grew even further, although the European equity market received a significant tailwind from the pursuit of unconventional monetary policies in the euro area.

Overall, this leads to the conclusion that European credit is in no way a substitute for a portfolio mix of safe-haven assets (Bunds) and equities, but a standalone asset class with a superior risk-return profile due to the built-in diversification benefits of being simultaneously invested in term- and credit-premia.

The capital market environment has certainly changed dramatically during the last 20 years, with negative core sovereign yields basically seen over the whole maturity spectrum and considerable curve-flattening over the recent months. The amount of realised term premia that we have seen over the last few years will surely be hard to repeat. Nevertheless, diversification benefits were still present, even in an environment shaped by unconventional monetary policy, so there is some evidence that familiar correlation patterns might not vanish altogether and European investors should still be in a position to set up diversified portfolios.

Despite recent spread tightening, average investment grade credit spreads are close to their historical averages, leaving the potential for credit-excess returns intact. Thus, European credit is a vital alternative and belongs in a diversified portfolio with the potential to deliver superior risk-adjusted returns and additional diversification benefits. As the market environment could become more challenging in the next couple of years due to the prolonged period of negative core yields, the potential to generate extra returns over and above a standard market benchmark through active management will become increasingly relevant to investors. «