The European Securities and Markets Authority (ESMA) has released its latest ‘Trends, Risks and Vulnerabilities’ (TRV) report, finding that fixed income markets continued to recover in the second half of 2020 with strong valuation increases over the summer for investment-grade (IG), emerging market and high yield (HY) debt. These all ended the year with valuations well above pre-crisis levels, according to ESMA. This recovery was seen as swift when comparing the impact of the COVID-19-related market stress on bond indices with previous crises, such as the global financial crisis or the European debt crisis.
The report noted that although the “grim economic outlook and increase in credit risk could have weighed on debt markets, this rebound is linked to the massive and ongoing monetary and fiscal policy support in response to the COVID-19 pandemic.”
As most central banks expanded their balance sheets by launching targeted asset purchases and increasing liquidity operations, in the Eurozone area, European Central bank’s asset purchasing programme reached EUR 757 bn of cumulative net purchases in December.
At the same time, the extension of fiscal support measures and the necessity for companies to meet their liquidity needs, combined with the continuing low interest rate environment, drove increased sovereign and corporate debt issuances in H2 2020, noted the report.
“However, for fixed income markets too, the large valuation increases raise concern about a decoupling of bond market performance from the macroeconomic situation,” ESMA wrote. “Moreover, in the medium to longer term, higher sovereign and corporate debt levels point to sustainability issues, leading to potential reassessment of credit risk going forward.”
For corporate and sovereign bonds, the rates of settlement fails during H2 2020 were on average 1.9% and 2.3% respectively, around longer-term averages, but also slightly increasing towards the end of H2 2020.
In sovereign bond markets, ESMA found both EA sovereign yields and credit default swap (CDS) spreads have continued to decline after the ECB’s announcement of the PEPP and the agreement of the EUR 750 bn EU recovery fund package in July, financed by jointly issued EU debt that will replace some of the national debt issuance. Countries that were more affected by the crisis, such as Spain and Italy, saw the biggest declines Narrowing bid–ask spreads mirrored these developments.
Corporate bond spreads in the EA continued their decline across sectors and across the rating spectrum. Amid continuous corporate bond issuance in 2H20, yields continued their decline across all rating categories to go below their pre-pandemic levels, indicating renewed search-for-yield behaviour. A strong indicator is the move to constant negative yields for the highest corporate bond ratings since October (T.22). At the same time, overall credit quality remained stable, with the share of corporate outstanding amounts with no rating or a rating of BBB or lower at 50 % in 2H20 (T.23).
“In the second half of 2020, credit rating activity continued the stabilisation pattern established following the dramatic spike in downgrades in March and April 2020,” ESMA wrote. “From late spring, the pace of downgrades slowed and then levelled later in 2020, as shown below for corporates This reflected an improving credit risk outlook, following the unprecedented fiscal and monetary actions taken earlier in 2020, and the relaxation of confinement measures in many jurisdictions over the summer and the associated recovery in economic activity.”
ESMA also found corporate rating activity continues to show strong differences across sectors. For example, in an August 2020 scenario-modelling analysis of European corporate credit risk, S&P identified the energy, metals and mining sectors as particularly vulnerable, with pharmaceuticals, utilities and real estate industries expected to maintain a less risky credit profile.
The fall in downgrades relative to upgrades was also seen in asset classes other than corporates. All asset classes initially experienced a sharp fall in ratings drift in early spring, but from June onwards experienced a recovery in ratings drift. By late 2020, ratings drift recovered to near or above zero for all asset classes, except non-financial corporates. The close-to-zero drift indicates that for sovereigns (including public ratings), structured finance and financial firms the pace of upgrades and downgrades was similar.
Vuk Magdelinic, CEO of AI pricing analytics provider Overbond, said, “The report is correct to highlight the potential for credit risk in both corporate and sovereign bond markets. However, there is also liquidity risk, in particular for the higher-grade bonds that investors searching for yield have been trading in greater volumes. Looking at Overbond’s COBI-Pricing data for European corporate bond markets from January to March this year, we can see that spreads for 10 year BB have increased by almost 30 bps compared to 4bps for BBB and 3bps for A and AA. This suggests that the liquidity risk is already visible down the curve and is something that investors will need to be weary of going forward. To counter this risk, firms need to be analysing more data aggregated across the different sources of liquidity for these markets.”
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