The official blog of BNP Paribas Asset Management

2020 – Challenges ahead for corporate debt markets

After strong performance in 2019, risk premia in corporate debt markets are low, meaning there is little cushion should profit margins be squeezed. We assess the outlook for corporate debt in the US and eurozone.

  • Different elements of companies’ debt-to-earnings ratios are of concern to investors, depending on the region (US or eurozone).
  • In the US, the focus is on the debt component: net debt has more than doubled since 2008.
  • In the eurozone, investor concern centre on earnings: many companies are struggling to generate consistent, strong profit growth.

The original hope, among investors, was that companies would take advantage of the low interest rates to pay down debt. In fact, many have responded to the monetary policy incentives in precisely the opposite way: they have refinanced existing debt and then borrowed even more, often to finance share buybacks.

In a low interest rate world, are higher debt loads less of a burden?

However, if the future is one of persistently low interest rates, high debt levels are not obviously a burden. But what about earnings?

The latest earnings reports have shown a continued deterioration in EBITDA-to-interest expense coverage ratios in both the US and the eurozone. They have remained historically high in the US,  while improving in Europe since 2016 (see Exhibit 1).

Exhibit 1: Deteriorating debt coverage ratios (as measured by EBITA-to-interest expense coverage ratios) for companies in both the US and Europe are, in our view, not good news for debt holders, although debt levels are arguably less of a burden in a world of persistently low interest rates - The graph shows changes in the coverage ratio (EBITA-to-interest-expense) for US and European companies on a trailing 12-month basis through September 2019

fixed income outlook jan 2020 credit 1

Data as at 3 January 2020. Source: FactSet, JPMorgan, BNP Paribas Asset Management

This follows a year of practically zero year-on-year earnings per share growth alongside nearly 30% gains in equity indices. This seemingly contradictory outcome was driven primarily by rising price-earnings multiples as recession and trade war fears waned, coupled with a declining discount rate as government bond yields fell.

Analysts’ forecasts are ever optimistic: expectations are for EPS gains of 8-10% in 2020. Even if this turns out to be too rosy, we still expect a recovery in earnings growth and hence better coverage ratios. Much of the weakness in the eurozone in 2019 was related to the commodity sector, and additionally semiconductors in the US. Both these sectors should see more stable prices in 2020.

Are the valuations appropriate for a modestly positive outlook?

After both investment-grade (IG) and high-yield (HY) corporate bonds handsomely outperformed government bonds in 2019, yield spreads are now at challenging levels. IG and HY risk premia for US corporate bonds are near the lows seen over the last 10 years (see Exhibit 2). There leaves little cushion for investors if rising wages and/or higher-than-expected US Treasury yields start squeezing company margins.

That said, with carry having been a dominant component of excess returns in recent years, we think that many investors have been viewing corporate debt as a ‘buy and hold’ play. We expect this sentiment to persist through Q1 2020, even if risk premia are range-bound. Consequently, we are modestly positive on US IG corporate bonds.

Exhibit 2: Risk premia for both investment-grade and high-yield corporate debt in the US and Europe are near the lowest level seen in the last 10 years. As such, we fear they offer investors little protection should company margins be squeezed - The graph shows the range in risk premia for IG and HY corporate debt in the US and eurozone during the last 10 years and the latest level

fixed income outlook jan 2020 credit 2

Data as at 3 January 2020. Source: FactSet, JPMorgan, BNP Paribas Asset Management

In the eurozone, technicals have helped foster a structural bull market for IG credit that should continue. Much of the expected demand related to the ECB’s asset purchase programme is likely priced in already, but the open-ended nature of the scheme is certainly a tailwind.

Furthermore, high net issuance in the eurozone has meant that the ECB holdings of credit have actually fallen as a percentage of the eligible bond universe. This leaves the ECB with plenty of capacity to ramp up its objectives quickly compared to other asset classes.

Simultaneously, we expect eurozone HY to benefit from a gradual pick-up in growth and lower tail risk – most recently, with the decline in the probability of a no-deal Brexit.

Niches offer opportunities

Lastly, we think there are notable opportunities in niche segments such as ‘additional tier-1’ (AT1) securities and contingent convertible capital instruments (CoCo bonds) which absorb losses when the issuing bank’s capital below a supervisor-determined level. Valuations look attractive. Risks are now lower given that the ECB’s new TLTROs have improved many banks’ liquidity positions.

Successful strategies will require nimble allocations to benefit from any moves to the extremes by range-bound markets. One can only be thankful, then, that US president Trump has shown himself to be more than able to fan market volatility.

This is an extract from our fixed income outlook for the first quarter of 2020

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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