Analysts at RBS Macro Credit Research stated that the firm’s Junk Bond Indicator (JBI) shows that U.S. bonds are over-valued, but European high-yield still offers value based on four factors including credit quality, credit issuance, M&A activity and valuation.
The research firm’s JBI indicated that yields are declining across credit and high-yield bonds globally. M&A activity is increasing and structured already recovered in the United States. In Europe, there is no sign of recovery for structured products.
One More Good Year for Corporate Bonds
The analysts noted that the great rotation is starting to happen in the United States, but investors remain searching for yield in the European region. Funds are flowing out of Treasuries and high yield debt while equity inflows are more resilient.
In terms of rates, the analysts suggested that European rates will likely increase, but less than U.S. yields due to policy divergence. Federal tapering, further easing, and lower-for-longer rates in Europe mean divergence in yield.
According to the analysts, Europe will experience another good year for corporate bond returns as credit performs well in low, positive growth, and stabilization of tail risk environment. They projected that total returns for will be 11 percent for high-yield and 4 percent for investment grade.
Circular Policies Still Working, Credit Stabilizing
The analysts observe that countries in European regions like France and Spain are in a stage of stabilization in terms of credit. Based on their forecast, the real GDP growth rate of France is -0.1% and -1.6% for Spain.
The analysts noted that the circular policy in Spain, “I buy your debt, you buy mine” is working for now. Spain’s public debt will be above 100% of GDP if the government supports banks and regions. Based on the Q2 2012 regional debt statistics, the total regional debt in Spain was €150.6 billion including o/w bonds €64.9 billion and o/w loans €85.6 billion. The regional debt/GDP was 14.2% including public entities debt/GDP was 15.4%.
Small Banks Vulnerable
RBS analysts observed that the regional deficit in Spain improved substantially in 2012. The average deficit was 1.7%. Some of the regions with higher than the average deficit include Valencia 3.5%, Murcia 3%, Catalunya 2%, and Beleares 1.8%. Large banks in the country are resilient, but small banks are exposed to rising bad loans. They noted that the rising unemployment results to bad loans on mortgages, which hurts banks and the sovereign.
The Spanish government is at risk if savings and deposits decline because it is heavily dependent of domestic demand for refinancing. The country has the domestic bank holdings of sovereign debt, which is nearly 35%.
On the other hand, the analysts noted positive signs that Spain’s economy is re-balancing. The country’s export level is showing recovery and labor cost readjustments (lower compared to core Europe). Currently, the analysts stated that improvement in the economy is overshadowed by decline in domestic demand.
Labor and Education are Key to Long Term Stability
The analysts also revealed that based on the OECD Going for Growth 2013 Priority Reforms, Spain should make wages more responsive to economic and firm-specific conditions. Last year, firm-level agreements were prioritized over higher-level agreements. Firms with declining revenues over the previous two quarters can unilaterally change employment contracts. A compulsory arbitration was also introduced to increase the scope of opt-outs from collective bargaining outcomes. Spain is encouraged to abolish the legal extension of collective wage agreements, and to improve active labor market policies. The Spanish government should introduce comprehensive monitoring and evaluation of services and labor market programs at the regional level. Monitor benefit recipients’ job search efforts more closely and link benefit payments to results, and phased out hiring subsidies and extend training for the unemployed. The country should also improve educational attainment in secondary education and access to tertiary education, and reduce disincentives for older workers who want to continue working.
In France, the analysts noted that banks are attractive, but corporate and government bonds are tight. The analysts cited that they are long on Societe Generale SA (EPA:GLE) (OTCMKTS:SCGLY) and Credit Agricole SA (EPA:ACA) because they have low exposures on periphery holdings and legacy assets.
The analysts noted that France exports became less competitive. Higher labor cost causes the slow growth of the country’s exports.
According to the analysts, the revisions to Moody’s Corporation (NYSE:MCO) ratings methodology might result in downgrades on French banks, which benefited from the existing system by being placed 3 notches higher on long-term ratings from sovereign support.
Based on OECD Going for Growth 2013 Priority Reforms, France need to reform job protection and strengthen labor market policies. The recommendation is for the French government to reduce the protection on permanent contracts, reform unemployment benefits to ensure they are generous in the short-term, but less later on, reduce minimum wage to the median, and reduce social security contributions further, and increase real property and inheritance tax. The French government is also encouraged to improve equity and outcomes in primary and secondary education.
