Fixed Income

Euro corporate bonds: life after QE and rate hikes

We look at why investors shouldn't write off euro investment grade credit as the ECB considers tighter policy

07/26/2018

Kristjan Mee

Kristjan Mee

Strategist, Research and Analytics

Many investors may be fretting that the end of the European Central Bank’s (ECB) quantitative easing (QE) programme later this year spells bad news for credit. The conventional view is that the end of large-scale bond buying, accompanied by rising interest rates, will undermine returns from fixed income assets. Our research questions that assumption. Our modelling suggests that holders of credit can continue to expect positive returns unless rates rise much faster than expected.  

We recently published research on the relationship between rising interest rates and US investment grade corporate bond returns. Here we use a similar approach to look at what the effect of rising interest rates could be in Europe, given the region’s much lower bond yields and less mature economic cycle. 

One of the most striking differences between euro and US corporate bonds is that the former have, on average, much shorter maturities – only 7% of the market has a maturity greater than 10 years compared with nearly a third in the US (see Figure 1). The weighted average modified duration of euro corporate bonds is consequently just 5.7 years compared with 7.3 for their US counterparts. All else being equal, this means that euro corporate bonds should be less sensitive to interest rate movements. On the other hand, yields are exceptionally low, so despite a relatively steep yield curve offering substantial roll-down income, euro corporate bonds have much lower total carry of only 1.9%, or less than half the 4.5% offered by US bonds. This does not provide much of a "buffer" to absorb any potential losses from yields rising.

Figure 1: US Corporate and Euro Aggregate Corporate indices’ key characteristics

IndexPercentage of index with maturity less than 10 yearsDurationYield to worst (A)Roll-down (B)Carry (A+B)OAS
US Corporate 68% 7.32 4.0 0.45 4.45 123
Euro-Agg Corporate 93% 5.67 1.0 0.89 1.89 122

Source: Schroders and Barclays. Data as at 29 June 2018

To understand the sensitivity of euro corporate bond returns to movements in interest rates, we have mapped out three possible scenarios for the path of German Bund yields. In doing so, we have made assumptions on how the option-adjusted spread (OAS) might behave in each scenario. The scenarios are assumed to play out over a three-year period, from June 2018 to June 2021 (see Figures 2 and 3).

Gradual normalisation (base case) – This assumes the ECB ends the QE programme in 2018 and hikes the deposit rate in the third quarter of 2019. The slope of rates as they rise would be relatively gentle as inflation moves slowly towards the 2% target. The one-year Bund yield rises from -0.6% to 0.8% and the 10-year yield from 0.3% to 1.7% by June 2021. We assume the option-adjusted spread (OAS) over Bunds falls from 122 basis points (bps) to 90bps as political tensions ease and the euro area growth remains stable at around the 2% level.

Faster normalisation – Here we assume that inflation takes a surprise turn upwards and growth accelerates. The ECB becomes more hawkish and therefore willing to raise rates. The one-year Bund yield rises to 1.7% and the 10-year yield to 2.1%. The OAS remains at 122bps, despite the better economic environment, as significantly tighter financial conditions break the usual negative relationship between Bund yields and credit spreads.

Slower normalisation – This presumes that the euro area recovery continues but at a slower pace, possibly due to political instability. The ECB pushes back the first rate hike into 2020. The one-year Bund yield rises to only 0.3% and the 10-year yield to 1.2%. The OAS increases to 150bps in 2019 and falls gradually to 130bps by June 2021. 

Figure 2: German Bund yield assumptions

Yield assumptionsLatestJune 2019June 2020June 2021
 1-year / 10-year1-year / 10-year1-year / 10-year1-year / 10-year
Faster normalisation -0.6% / 0.3% 0.0% / 1.0% 0.5% / 1.7% 1.2% / 2.1%
Gradual normalisation (base case) -0.6% / 0.3% -0.2% / 0.8% 0.3% / 1.4% 0.8% / 1.7%
Slower normalisation -0.6% / 0.3% -0.4% / 0.1% -0.2% / 0.5% 0.3% / 1.2%

Source: Schroders at Barclays. Data as at 29 June 2018

Figure 3: Euro Aggregate Corporate Index OAS assumptions

Yield assumptionsLatestJune 2019June 2020June 2021
Faster normalisation 122 122 122 122
Gradual normalisation (base case) 122 112 102 92
Slower normalisation 122 150 140 130

Source: Schroders at Barclays. Data as at 29 June 2018

Figure 4 shows the annual returns in each scenario, broken down into yield, roll-down, duration and spread components. Figure 5 displays the three-year annualized returns for the three scenarios and if there is no change. As “no change” means yields do not rise at all, the returns exceed the three outcomes discussed below.

Gradual normalisation (base case) – In this instance, returns are close to zero in the first two years as returns from yield, roll-down and spread narrowing are cancelled out by the duration loss from rising yields. In the third year, the return is positive at 1.4%, buoyed by smaller duration loss and higher yield income. This positive return in the third year is enough to push the three-year annualized return to 0.5%.

Faster normalisation – Here the losses in the first two years are -1.4% and -0.4% respectively. Returns again turn positive in the third year thanks to the much higher level of yield income, but this is insufficient to prevent the three-year annualised return being negative (-0.4%). On the positive side, this is quite an extreme scenario, with the one-year Bund yield rising above 2.1%, yet it is only projected to result in small losses for euro corporate bond investors.

Slower normalisation – This assumes that the slower pace of rate hikes means that the duration losses are smaller than in the base case. Even so, the three-year annualised returns are almost identical in the two scenarios due to the spread widening that is assumed to take place here. Slower normalisation also means that investors benefit from lower average yield income overall.

Conclusion

While the low yields on offer certainly make euro corporate bonds vulnerable to a rise in interest rates, investors can take a degree of comfort from our analysis. In two of the three scenarios we have looked at, European bonds are projected to deliver positive annualised returns. Even in a sharply rising interest rate environment, three-year losses are projected to be relatively low. Perhaps the main lesson to be drawn here is that the network of factors affecting corporate bond returns is complex. Investors would therefore be unwise to take drastic action based on a view about a single variable such as ECB policy rates. A more nuanced approach which also takes account of the other drivers of returns is likely to be more appropriate.  

Figure 4: Annual returns in our three scenarios (%)

Gradual normalisation

gradual_normalisation_annual_return_scenario

Faster normalisation

faster_normalisation_annual_return_scenario

Slower normalisation

slower_normalisation_annual_return_scenario

Source: Barclays and Schroders. Data as at 29 June 2018

Return forecasts are not a reliable indicator of future performance.

Figure 5: Three-year annualized scenario returns (%)

three_year_annualised_return_scenario

Source: Barclays and Schroders. Data as at 29 June 2018

Return forecasts are not a reliable indicator of future performance.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.