- A comparison between short-dated and longer-dated investment grade euro-denominated corporate debt suggests front-end investors receive a similar yield and spread, without any deterioration in the credit fundamentals, according to our analysis.
- While it remains imperative to always approach each issuer on a standalone basis, we believe, the short-dated euro corporate universe provides a particularly compelling risk-reward opportunity in the current market.
Euro-denominated investment grade (IG) spreads have resumed rising since tightening in mid-September as the deterioration of credit fundamentals has added to recession fears in the eurozone.
The impact of inflation and the European Central Bank’s successive rate hikes seem to have finally filtered through to companies’ income and cashflow statements.
IG corporate (non-financial) leverage has risen to 3.3x in the second half of the year from a record best of 2.8x in Q4 20221.
As we head into 2024, concerns are growing that elevated yields (both rates and spreads) will increase borrowing costs to the point that ratings will be affected.
However, the corporate fundamentals and metrics that we feel most effectively gauge front-end risk (one to three years in the duration) remain very stable and we see a very positive value proposition given the rise in yields (rates and spreads) seen over the last year.
The corporate fundamentals and metrics that we feel most effectively gauge front-end risk remain very stable
Our approach to assessing risk in the front-end of the corporate curve is straightforward. In our view, liquidity is the foremost component of financial risk over any 12- to 36-month horizon.
Unlike most other risk factors of a given issuer (such as leverage, interest coverage etc.), a lack of liquidity can precipitate the default of an otherwise healthy security. We have seen this many times.
A useful quantitative measure of a particular issuer’s liquidity cushion is the metric of liquidity sources divided by uses over a given period of between 12 and 24 months. Simply put, this measures an issuer’s ability to fund on-going operations without refinancing its short-term and current portion of long-term debt.
As sources of liquidity for IG non-financial issuers in the simplest terms we include:
- Cash on the balance sheet
- All available undrawn and committed credit facilities maturing beyond 12 months, and
- Forecasted cash flow from operations.
- All debt maturities
- Forecasted capital expenditures (CapEx) including estimated discretionary spending and
- Expected dividends, if any.
As a basic rule of thumb, we start with the standard measure of liquidity strength for 12-24 months and then adjust to the specific situation of a given issuer and market conditions.
- 1.0x-1.1x: Weak
- 1.2x-1.5x: Adequate
- 1.5x-2.0x: Strong
- 2.0x or greater: Exceptional
To highlight the current state of liquidity within the backdrop of the last few years, we compiled liquidity data as the weighted average for 60 S&P-rated BBB euro non-financial issuers which are current constituents of the ICE BofA 1-3 Year Euro Corporate Index2. As a point of reference, we have highlighted the corresponding period-ending option-adjusted spread (OAS) for the index as well as the index yield to maturity for the ending period3.
Figure 1: Euro BBB non-financial liquidity cushion
Figure 2: ICE BofA 1-3 Year Euro Corporate Index – option adjusted spread (OAS)
As is evident from the data, the IG non-financial liquidity remains stable during the period and has seen little fluctuation through the rise in yield (rates and spread).
According to our analysis, a comparison between short-dated and longer-dated euro-denominated investment grade corporate debt at the present time suggests an investor will a receive similar yield and spread, without any deterioration in the credit fundamentals. While it remains imperative to always approach each issuer on a standalone basis, we believe, for the reasons outlined, the short-dated euro corporate universe provides a particularly compelling risk-reward opportunity in the current market.
1 Bloomberg Intelligence as at September 2023
2 Bloomberg, S&P Capital IQ credit statistics as at June 2023