European Bonds Attract Traders After Wall Street's Recommendation

As Wall Street starts unveiling its 2023 outlooks, one early favorite is emerging: Europe’s safest corporate bonds. These bonds offer investors a safe haven amid concerns about the global economy, and they are expected to continue to perform well in the coming years.

So strong is the bullish sentiment around these bonds that traders have helped drive down their yield premium over government debt by the most in two years. This is a clear sign that investors are confident in the future of the company and believe that the bonds are a good investment.

Gains in the European corporate bond market are part of a broader rally in global credit markets, driven by optimism that both inflation and central-bank rate increases are beginning to slow. In Europe, where even the strongest corporate borrowers were battered in the bond market earlier this year as Russia's invasion of Ukraine throttled the region's economy, the rebound is more pronounced.

Since mid-October, Euro investment-grade debt spreads have tightened by 47 basis points to 187 basis points. While spreads are still wide, this marks the biggest drawdown since 2020, according to data compiled by Bloomberg. This suggests that skepticism about the European economy may be easing.

Matthias Schell, a credit strategist at Landesbank Baden-Wuerttemberg, believes that the worst of the performance issues in the market are over. He also believes that current yields in investment-grade securities are very attractive. Schell believes that investors will put more money into credit in the near future.

Strategists are bullish on Europe next year, citing factors such as an expected improvement in sentiment as China eases Covid restrictions and mild weather helps avoid a gas shortage. They also point to cheap valuations after a historically bad year as a key catalyst for further gains.

BlackRock is seeing a rotation into credit funds as investors return. This is according to a recent report from the firm.BlackRock is seeing a rotation into credit funds as investors return, according to a recent report from the firm. This shift could be a sign that investors are becoming more confident and are willing to take on more risk.

According to Bank of America Corp. strategists, there are early signs that money is flowing back into the market. High-grade funds have recorded four weeks of inflows, while junk bond funds have seen 13 weeks of outflows.

Traders have been known to make early bets on central bank policy changes, but with Europe on the brink of a recession, there is a risk that any optimism in the markets may be misplaced.

S&P Global analysts have predicted that "painful times" are ahead for weaker borrowers. They pointed to a stress test of 20,000 companies, which showed that a combination of weaker growth, high inflation, and interest spreads would cause the proportion of potential defaulters to reach 17% by 2023. This is up from 7% in 2021.

According to analysts like Peter Kaufmann at Erste Group Bank AG, valuations are already taking the bad news into account. The yield on euro investment-grade bonds stands at 3.93%, compared with a five-year average of 1%, based on Bloomberg indexes.

"Many of the negative developments have already been priced in," he said.