European markets continue to be volatile

Good morning. This is Harriet Clarfelt filling in for Mr Armstrong as he is on well-deserved leave. If you have any complaints or other comments about Mr Armstrong, please send them to harriet.clarfelt@ft.com.

I myself was on holiday last week, and Rob has just returned from sunnier climes, so perhaps he took that into consideration when searching for a well-rested colleague.

Back home in London, the weather was unlikely to be any better, but a quick trip across the continent to Austria and France gave me the opportunity to take a closer look at European markets (and dumplings, schnitzels and many other starchy foods).

So, let’s move on to OAT.

French government bonds, also known as OATs (short for official assimilable bonds), have been going through a turbulent period since President Emmanuel Macron called surprise parliamentary elections two Sundays ago.

Yields on 10-year French government bonds rose sharply last week as bond prices fell, and the spread, or difference, between French and German benchmark yields, taken as a barometer of the risk of holding French debt, widened by more than 0.8 percentage points last Friday to its highest level since 2017.

As my colleagues have amply reported, other French markets have also been under pressure over the past two weeks as investors digested the possibility of a far-right government with huge spending plans and the formation of a left-wing coalition that could destroy Macron’s centrist alliance.

Last week, the CAC 40 index recorded its worst drop since 2022, leading to a sharp rise in borrowing premiums for European companies, as discussed below.

So 1) what do these rising premiums mean for companies with euro-denominated debt? 2) could this increased volatility represent an opportunity for would-be investors?

My answer, in short, is this: 1) Companies using the European investment grade bond market are currently having to pay record premiums in the space of a few weeks to issue bonds, which is not ideal if you were planning to do a big deal in the near future.

And 2) maybe, if you believe that further turmoil won’t last long past France’s two electoral battles on June 30 and July 7. Of course, individual credit choices matter, but so does the fact that France is not the only country holding elections this year.

First, the numbers: The average spread on euro zone investment-grade bonds — the premium that borrowers pay when issuing debt over the equivalent yield on German bunds — is about 1.2 percentage points, reaching its highest level since February last week.

This is still significantly lower than six months ago, but significantly higher than the level of just 1.06 percentage points in early June.

The average spread on high-yield bonds, or so-called “junk” bonds, is also down significantly from last year, but jumped this month to just under 3.5 percentage points from 3.21 percentage points, according to data from IceBank of America.

For Lotfi Karoui, chief credit strategist at Goldman Sachs, the moves reflect “uncertainty.” [about] “This is due to the election results and investors’ lack of clarity about the economic policies of different players.”

To be sure, U.S. corporate bond spreads also widened in June, but the move was less pronounced and less directly correlated than across the Atlantic, with the difference between investment-grade spreads in the two regions reaching a four-month high earlier this week.

That might tempt some to stay in the dollar market for now until the volatility in Europe subsides.In a sign that the U.S. market is open to new issuance and that demand from investors remains strong, several large bond offerings have been made this week, including Home Depot’s nine-part $10 billion bond offering, which closed on Monday.

But are we witnessing a more permanent change? There is an argument to be made that spreads have been too narrow for the risks they should be reflecting and it is time for them to widen. Indeed, as Mike Scott of Man Group puts it: “France is a very good bet.” [has] It triggered a reassessment of risks that had not been adequately priced.”

“We remain comfortable on credit in absolute terms” and “the likelihood of a systemic political shock in Europe is overstated,” Deutsche Bank analysts wrote this week. But they added that European credit should now trade at a wider spread to U.S. credit “given both political concerns and the ECB’s apparent reluctance to differ from the Fed on rate cuts.”

In fairness, euro credit spreads are slightly lower than they were last week. (It’s an occupational hazard of market journalists to choose to write about a topic and then desperately watch as the trend starts to break down.)

This may be a sign that concerns are already starting to ease.

And if you believe the market’s worst political fears are unlikely to come true and the volatility won’t last too long, now could be a good time to pick up some slightly cheaper bonds.

“People have been frustrated by the tightening of credit spreads,” said Christian Hantel at Vontobel. “Now, if you look at the widening of spreads in Europe, and assuming the damage to the French political situation is limited, this could be an interesting opportunity for investors to get in.”

Analysts at JPMorgan agree: “Despite the many risks, our view is that this ultimately presents a buying opportunity,” they wrote last Friday, noting that “European investors are accustomed to political risk.” Meanwhile, “technicals” — investor flows into euro high-grade bond funds — remain “quite solid.”

My take? Opportunistic buying based on the assumption that volatility will continue to subside still requires a great deal of caution about individual company prospects and credit quality in any political scenario.

Needless to say, we are conscious of the wider international situation we find ourselves in, with the UK elections this year in between the two French elections and, of course, the US elections looming in November.

Then there’s the issue of when and how much central banks will cut interest rates, as well as debate about the broader economic outlook.

Man Group’s Scott said that with a number of elections coming up, “volatility is going to continue,” but when it comes to high-yield credit, “the growth backdrop is going to be more important in general.”

Default is different

The latest monthly corporate default report is out and contrary to some of the fears voiced over the past year, things aren’t looking too bad – but they’re not looking too good either.

According to S&P Global Ratings, there were a total of 14 global defaults in May, bringing the year-to-date total to 69. That’s two fewer than the comparison period in 2023. But, as S&P puts it, it’s still “significantly above” the five-year average.

Default numbers in May also highlight regional differences: The United States had more defaults than Europe last month, with 9 defaults compared with 4. But U.S. defaults fell from the previous month while European defaults remained steady, leaving the region with 19 defaults so far this year, the highest since 2008.

Moreover, 11 of the European defaults were attributable to so-called distressed exchanges.

These types of debt-swap deals can help companies (and their private equity backers) avoid costly bankruptcy proceedings, although our previous reporting has said that distressed-debt swaps sometimes just postpone the issue to court anyway.

S&P and Moody’s expect default rates to trend downward over the next 12 months, but that will depend in part on trends in interest rates, growth and geopolitical developments.

Weaker corporate debtors, especially leveraged loan issuers whose borrowing costs rise and fall with interest rates, will be eagerly looking for signs of relief in the near future.The problem is that central banks are unlikely to speed up the pace of rescue unless they face a sharp slowdown in growth.

And such an environment would not be good for highly indebted, low-quality companies either.

Good read

Hertz has raised new capital to make room.

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