Three Reasons to Explore Europe’s Corporate Bonds

Braced for a Bumpy Ride

Sometimes 2016 felt like a white-knuckle ride as investors braced themselves for the fallout from the political shocks posed by Brexit and Donald Trump’s election in the US. In the event, financial market turbulence immediately after these events proved relatively short-lived. But huge uncertainties lurk beneath the surface calm—and have scope to trigger renewed volatility.

Against this backdrop, Europe’s corporate bond markets look like a relative beacon of stability in 2017. Whatever happens, European credit is going to benefit from three weighty ballasts: a highly supportive policy backdrop; solid investor demand versus the supply of bonds to buy; and European companies’ thrifty borrowing habits.

The Big ECB Backstop

The European Central Bank (ECB) is firmly committed to keeping regional interest rates lower for longer—and is sticking with its quantitative easing (QE) bond-buying program. The pace of monthly purchases of regional sovereign, covered and corporate bonds will slow slightly from April. But the ECB is extending QE for an extra nine months so that it runs through to at least December 2017.

In addition, the ECB is tackling the technical challenge of finding enough eligible bonds to buy each month by including short-term government debt in the program, while also conceding that it may now buy negative-yielding bonds.

So QE will remain a crucial backstop for regional bond markets throughout 2017, putting a solid floor under euro-area bond prices and helping to anchor regional bond yields.

Issuance Levels Are Muted

Supply and demand dynamics in European credit are a further positive. The vast majority of euro-area corporate borrowing is still funded by bank loans—by contrast with the US, where most funding comes from bond markets. European corporate bond issuance has been growing, but so too has demand from bond buyers seeking out higher-yielding assets as government bond yields have lurched ever lower. Buying demand continues comfortably to outstrip the supply available, which is positive for bond creditors and prices.

In 2017, demand should get an extra kick from the rising (and volatile) costs of currency hedging. For euro-based investors who choose to hedge their currency exposure, these costs now take a big bite out of the returns generated by buying US dollar–denominated bonds in particular. More expensive dollar hedging costs will likely bolster their demand for euro-denominated bonds.

Europe’s Borrowers Are Thrifty

A lot of Europe’s new bond supply is being issued to refinance existing debt as companies lock in long-term funding at cheap rates. This refinancing trend shows that European companies are proving cautious with their balance sheets. They aren’t overloading on debt—indeed, many are actively deleveraging. And they aren’t borrowing in ways that could benefit shareholders but imply extra risks for holders of corporate debt—like issuing bonds to pay for acquisitions or to buy back shares.

By contrast, US companies’ borrowing has been creeping up and more bond issuance is funding acquisitions or share buybacks. This behavior shows that US companies are further along in the current credit cycle than their European counterparts. Europe’s earlier credit cycle dynamics count in its favor, and should help ensure that corporate bond defaults remain few and far between and continue to lag levels in the US.

Countering Political Challenges

Europe undoubtedly has a tricky political calendar to navigate in 2017, given important elections in France and Germany, plus major uncertainties over Brexit. These challenges may well trigger bouts of market volatility. But the ECB is firmly committed to averting sustained turbulence and has powerful weapons in its policy arsenal. It can, for example, calibrate bond buying to tackle short-term volatility by adjusting the speed and composition of QE purchases as and when trouble spots arise.

This highly supportive policy backdrop contrasts markedly with the much less clear-cut outlook in several other big bond markets—and should help stabilize investor sentiment if political clouds start to gather.

Over and above a vigilant ECB, Europe’s corporate bond markets can count on strong buying demand for the asset class and broadly conservative behavior from European companies in 2017. In our view, these are highly positive certainties given the many uncertainties ahead.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.