The Stars May Be Aligning for EUR Credit

EUR Credit is among the most attractive segments of global fixed income, in our view. While spread compression has been a general phenomenon over the past few months in global fixed income, EUR credit spread valuation remains above its long-term fair value when looking at break-even spreads, in contrast to many other asset classes (Exhibit 1). There is no denying, however, that at about 110 basis points for the EUR Corp IG Index, the absolute level of spreads is considerably lower than in 2022, when central banks started their tightening cycles. With that in mind, spread compression may not necessarily be the key driver of total returns going forward. But it is important to highlight that the total yield valuation backdrop remains quite favorable (Exhibit 2). Specifically, the EUR Corp IG yield percentile rank over the past ten years currently stands at 88%, which means that yields were higher only 12% of the time during that period.

Given the current level of yields, the outlook for subsequent returns appears favorable. In the near term, the return outlook will depend on the expected moves for both rates and spreads (Exhibit 3). With the ECB signaling some policy easing in the pipeline, we believe that rates will likely move lower, thereby supporting expected returns for EUR IG in the process.

Over the medium term, we believe the outlook for expected returns is supported by the attractive level of entry yields. Entry points matter in fixed income. Given the attractive level of current yields, the outlook for expected returns has improved considerably. This is because there has historically been a strong relationship between starting yields like today’s and subsequent returns. For instance, at a starting yield of 3.82% for EUR IG, the median return for the subsequent five years — using a 30-basis-point range around the starting yield — stands at 5.11%, with a return range of 3.23% to 6.03% (Exhibit 4).

EUR IG credit remains supported by strong fundamentals. Despite the macro challenges that the eurozone has faced in the recent past, it is remarkable to see that the asset class fundamentals are still robust. We base our fundamental health indicator on three key variables: net leverage, EBITDA margin, and free cash flow to debt. Overall, our fundamental score indicates that the asset class fundamentals are healthy, having recovered markedly over the past six months (Exhibit 5).

On the growth front, recession risks in the eurozone appear to have receded. A stronger growth backdrop is likely to be supportive of risky assets in the region, including credit risk. Our business cycle indicator for the eurozone indicates that the outlook appears brighter in the period ahead (Exhibit 7), mainly reflecting an improvement in business sentiment.

The technicals backdrop for EUR IG remains favorable. We have observed that the demand for credit in the eurozone remains robust, as reflected by the subscription of new issuance and a solid pickup in cumulative flow dynamics since the beginning of the year (Exhibit 8). The strength of technicals is not a surprise given the supportive macro environment and anticipation of further ECB rate cuts.

We believe that EUR IG is well positioned against its peers. Relative to US IG, EUR IG’s break-even yield — the yield per unit of duration — is more attractive, at 0.88% against 0.76% for its US counterpart. It is also worth highlighting that EUR IG volatility averaged 4.8% over the past 10 years, considerably lower than US IG’s 6.9%. Away from the US, EUR IG’s valuation compares well with that of European sovereign credits with similar credit ratings. The EUR IG index carries ratings of A3/Baa1, which is broadly similar to that of Spain and Portugal. 10-year yields for Spain and Portugal’s government bonds currently stand at 3.35% and 3.23% respectively, compared with 4.70% for the 10-year+ yield of EUR IG (Exhibit 9). The valuation landscape also looks favorable for EUR IG when analyzing break-even yields relative to the yields of eurozone government bonds with the same credit rating (Exhibit 10). Finally, we also believe that EUR IG is set to outperform EUR cash in the period ahead given where we are in the ECB rate cycle as cash returns are likely to move lower reflecting the impact of future ECB rate cuts. In contrast, the longer duration of EUR IG means that the asset class’s future returns should benefit from policy easing.

MFS has a long history of being active in EUR fixed income. 

MFS has a deep history and expertise in fixed income that dates back to 1970. The firm was an early pioneer in the development of credit-oriented active bond management and started managing dedicated, credit-focused strategies in 1974.^₁ MFS has been investing in European credit for over a decade, with a London-based fixed income team in place since 2013. 

In addition, the MFS Meridian Euro Credit Fund launched in February 2019. The Fund’s objective is total return, with an emphasis on current income but also considering capital appreciation, measured in Euros. Focusing primarily on European corporate bonds, the fund seeks to deliver attractive levels of fixed income return from a diversified set of alpha sources. Portfolio Managers work with our credit analysts across our global research platform to ensure that preferred security selection ideas from our bottom-up research are aligned with top-down portfolio allocation decisions. 

A key feature of the fund is that, while it has always maintained an average credit rating that is investment-grade,^₂ it has made tactical use of off-benchmark securities with differing risk attributes such as high-yield,^₃ government-related and overseas corporate debt (currency hedged to euros). Flexing the opportunity set  in this fashion has supported the fund in seeking attractive levels of return but with more diversified sources of risk.

In our approach to fixed income credit investing, we often cite the importance of “being early to not being late” as part of our long-term investment horizon. The fund has a proven track record of successfully navigating periods of heightened volatility and taking advantage of market dislocations for the longer-term benefit of the portfolio. The I1 EUR share class has outperformed the benchmark over rolling 3-year periods on 100% of occasions since inception, with an average excess return of +74 bps per annum.^₄

Our euro credit capability is open to institutional investment through dedicated separate accounts or to retail investment through the Meridian Euro Credit Fund. The strategy is managed by lead portfolio managers Pilar Gomez-Bravo and Andy Li. 

Overall, we believe that the stars are getting aligned for EUR IG Credit, and we suggest that global fixed income investors should consider the asset class. MFS has been active in EUR fixed income for well over a decade, with a London-based fixed income team in place since 2013. 

The fund may not achieve its objective and/or you could lose money on your investment in the fund. 

Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio’s value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity. 

Derivatives: Investments in derivatives can be used to take both long and short positions, be highly volatile, involve leverage (which can magnify losses), and involve risks in addition to the risks of the underlying indicator(s) on which the derivative is based, such as counterparty and liquidity risk. 

High Yield: Investments in below investment grade quality debt instruments can be more volatile and have greater risk of default, or already be in default, than higher-quality debt instruments. 

Geographic: Because the portfolio may invest a substantial amount of its assets in issuers located in a  single country or in a limited number of countries, it may be more volatile than a portfolio that is more geographically diversified. 

Please see the prospectus for further information on these and other risk considerations.

Endnotes

^₁ In 1970, Keith Brodkin came to MFS from New England Life Insurance Company to lead the newly established FI group and manage the bond sleeve of a balanced fund, MFS^_® Total Return Fund (MTR). It was one of the first funds of its kind to include bonds as an integral component. Up to this point, bonds were generally owned by wealthy individuals and insurance companies, which held bonds as an asset to match their liabilities.
^₂ Credit Quality Rating Methodology: The Average Credit Quality (ACQR) is a market weighted average (using a linear scale) of securities included in the rating categories. For all securities other than those described below, ratings are assigned utilizing ratings from Moody’s, Fitch, and Standard & Poor’s and applying the following hierarchy: If all three agencies provide a rating, the consensus rating is assigned if applicable or the middle rating if not; if two of the three agencies rate a security, the lower of the two is assigned. If none of the 3 Rating Agencies above assign a rating, but the security is rated by DBRS Morningstar, then the DBRS Morningstar rating is assigned. If none of the 4 rating agencies listed above rate the security, but the security is rated by the Kroll Bond Rating Agency (KBRA), then the KBRA rating is assigned. Other Not Rated includes other fixed income securities not rated by any rating agency. Ratings are shown in the S&P and Fitch scale (e.g., AAA). All ratings are subject to change. The portfolio itself has not been rated by any rating agency. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/ issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively. The index rating methodology may differ.
^₃ Bloomberg Euro Aggregate Corporate Bond Index.
^₄ The strategy outperformed 27 out of 27 rolling 3-year periods and 37 out of 51 rolling 1-year periods to 30 April 2024. Source: Benchmark performance from SPAR, FactSet Research Systems Inc. It is not possible to invest directly in an index. Index performance will differ from our actively managed strategies, which may involve a higher degree of risk. 

Source: Bloomberg Index Services Limited. BLOOMBERG^_® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Bloomberg neither approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The views expressed herein are those of the MFS Investment Solutions Group within the MFS distribution unit and may differ from those of MFS portfolio managers and research analysts. These views are subject to change at any time and should not be construed as the Advisor’s investment advice, as securities recommendations, or as an indication of trading intent on behalf of MFS.