How to capitalise on euro credit opportunities in evolving markets

The recent rate cut in Europe and prospect for further ones, driven by softer inflation and a weaker economy, contrasts with uncertainty surrounding the US Federal Reserve's next move. This shift in monetary policy signals potential lower borrowing costs for European companies and governments, which could positively impact the credit market, albeit within the broader context of global economic and geopolitical dynamics. As such, we expect 2024 to deliver another positive year for the euro credit asset class.

We believe that in light of recent, and potential further, rate cuts by the European Central Bank, exploring the euro credit segment requires a flexible approach to select sectors and issuers with the best return potential, given the expected increase in spread dispersion between higher and lower quality issuers.

Indeed, the delayed impact of monetary policy on the real economy is likely to create disparities across issuers and sectors, favouring companies with strong financial positions while affecting those with weak balance sheets and excessive leverage.

In this context, a total return strategy may be effective due to its unconstrained nature, allowing for informed investment decisions based on thorough credit research analysis, and the ability to capitalise on the opportunities presented by the evolving credit landscape.

Generating potential opportunities

The high conviction in the positioning of our unconstrained approach stems from thorough research and analysis, which aims to identify sectors and issuers with strong growth prospects, sound fundamentals, and potentially attractive valuations. This level of conviction is supported by a deep understanding of the market dynamics, macroeconomic trends, and company-specific factors that contribute to the belief in the selected sectors and issuers.

The following sectors are ones where we feel there are opportunities available:

1. Financials

   We hold a positive outlook on the fundamental performance of European banks. In Q4’23, earnings were favourable, especially in Italy and Spain, but growth in the UK and France was less than expected. While profitability levels stayed strong, they were slightly lower than in previous quarters due to reaching the peak of net interest income (NII). Capital positions remained robust, reflecting strong earnings and modest risk-weighted asset (RWA) growth, despite increased shareholder distribution. The outlook for 2024 remains optimistic, but there may be an increase in provisioning in the coming quarters to account for potential economic challenges.

2. Utilities

   The sector provides a good balance between risk and potential reward. It has stable and defensive qualities, along with attractive valuations.

3. Real Estate

   The sector's attractive valuations, along with exposure to top-tier players in the investment-grade universe, give us confidence in the sector, especially in residential and logistics. However, we're currently underweighting the offices sub-sector.

Looking at euro credit with a total return hat on

Our total return approach aims to offer dynamic asset allocation and credit selection across the entire credit spectrum, without being constrained by a benchmark. The approach combines top-down active asset allocation leveraging on AXA IM global credit capabilities with bottom-up credit selection, aiming to identify sources of value, take advantage of market anomalies, and adapt to market fluctuations. The portfolio is designed to be flexible, proactive across market cycles, and managed transversally across risk buckets (DIA for Defensive, Intermediate, Aggressive) to respond to different market cycles.

This structure aims to provide consistent incremental returns over three-year rolling periods and allows for identifying key sources of alpha and achieving performance in all market conditions. Additionally, the DIA framework, managing duration risk transversally across buckets and proactive allocation across market cycles, should provide flexibility to adapt to risk and efficiently capture value in the market.

We are currently taking a barbel approach, skewed towards Defensive and Aggressive assets respectively. This approach typically involves investing a significant portion of the portfolio in low-risk assets (often short-term securities or highly rated bonds) while also allocating a substantial portion to high-risk, high-return assets (such as subordinated or high-yield bonds).

We expect to maintain this barbel approach throughout 2024. On the one hand, being very selective in our bond picking, relying on our thorough fundamental analysis. On the other hand, not ignoring the carry provided by the asset class. We believe it is high enough to offset near-term spread widening.

References to companies and sector are for illustrative purposes only and should not be viewed as investment recommendations.