Robin Marshall
- Why ECB policy rates may not come back down quickly.
- The consequences for investors if rates do not fall quickly.
- How to protect against such a scenario, as an investor.
After G7 policy rate increases in 2023, market expectations adjusted to the notion of ‘higher for longer’ on inflation and short interest rates, in Europe particularly. The initial causes of higher G7 inflation were disruption to supply-chains after Covid, and higher commodity and energy prices after the Ukraine shock. This affected the Eurozone acutely, given the high share of imported energy. But other factors, including labour shortages, and some evidence of wage expectations adapting to higher inflation, have also emerged.
Covid inflation morphed into a longer inflation shock
Chart 1: Eurozone labour market and inflation
Source: LSEG FTSE Russell/Refinitiv. Data to Oct 30, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures
Inflation errors suggest higher for longer rates
Central banks, including the ECB, may be reluctant to ease policy quickly, after criticism of excessive delay in tightening in 2021-22 when inflation accelerated, as Chart 2 shows. This is also a higher inflation environment than after the Global Financial Crisis (GFC) and Covid shocks of 2008-09 and 2020-21. In those cycles, central banks could move rapidly to zero rates and QE, with low inflation risks.
Chart 2 Regional inflation rates
Source: LSEG FTSE Russell/Refinitiv. Data to October 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures
The consequence of higher inflation risks in this cycle, and central bank sensitivity to another inflation error, is a rapid fall in ECB rates is less likely, barring another banking crisis.
…with lower risk of a Eurozone banking crisis
And the Eurozone banking system is far better capitalised than pre-GFC. Indeed, Eurozone banks now have 3.4% higher Tier 1 Capital ratios than US banks[1]. Eurozone banks increased Tier 1 capital ratios to 16.4%, and overall capital ratios to nearly 19% at end-2022[2] . Better capitalisation and less leverage in the Eurozone banking system reduce this to a tail risk.
Curve inversion favours short duration?
During the period of rising policy rates, in 2022-23, low duration investment vehicles, like bills and Floating Rate Notes (FRNs), insulated investors against the “death by duration” in longer maturity bonds. Frequent coupon adjustments in FRNs gave investors protection against rising yields, in contrast to straight bonds with fixed coupons and long duration. Inverted Eurozone yield curves also offer no reward for increasing duration risk.
FRNs offer protection against higher rates for longer
If ECB rates do not fall in 2023-24, and even increase further, FRNs offer investor protection in the 1,3 and 6 monthly coupon re-sets, which give the bonds duration of close to zero. Investors can either buy sovereign FRNs in the Eurozone, or corporate FRNs, with a high financial weighting, to protect against a protracted period of higher ECB policy rates.
Sovereign Euro FRNs mainly Italian issues
Sovereign FRN issuance is dominated by Italian issuance, which comprises over 70% of total issuance, and reduces credit quality. In addition, corporate FRNs still trade at relatively high credit spreads. This reflects widening in Eurozone investment grade spreads after the US and Credit Suisse banking crisis in March, as Chart 3 shows. IG spreads also converged less than High Yield spreads, HY benefitting from the risk rally and stronger correlation with equities. Indeed, IG spreads are still near levels reached during the Covid sell-off in 2020.
Chart 3: Eurozone IG & HY credit spreads since pre- Covid
Source: LSEG FTSE Russell, data to October 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures
But corporate FRNs are nearly all senior bonds
An attraction of corporate FRNs, is that all the bonds are senior (see Table 1).The FTSE Russell index also excludes FRNs rated below investment grade.
Table 1: Eurozone corporate FRNS by type of issuance
| Seniority | % by Market Value |
|---|---|
| Senior Unsecured | 69.20% |
| Senior preferred | 21.10% |
| Senior secured | 6.03% |
| Senior Non-Preferred | 3.58% |
Source: LSEG/Refinitiv. Data as of October 31,2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures
FRN bondholders protected by buffer of loss absorbing capital…
Senior FRN bondholders in financials are protected by a buffer of total loss-absorbing capital (TLAC), required by Eurozone regulators. These deeply subordinated Tier 1 bonds (like Cocos) are designed to absorb losses in the event of a banking crisis, as they did during the March 2023 “resolution” of Credit Suisse when CoCo holders were “bailed in”. This buffer offers protection to Senior bonds, which stand further up the capital structure, barring a catastrophic collapse in the Eurozone banking system.
FRNs have low correlation with equities & fixed coupon bonds
Finally, as well as being generally Senior bonds, Eurozone FRNs are a relatively standardised, and long-established debt instrument, with a high level of capital and coupon certainty. They are less complex than high yield credits, where covenant protection for investors, and liquidity, varies considerably.
From a portfolio diversification point of view, FRNs also tend to exhibit low correlation of returns with both straight government bonds, and equities, reflecting different risk/return profiles. In contrast, HY credits have higher correlation with equities, and are predominantly a risk-on asset, becoming more vulnerable in recessions, as default rates rise. These considerations suggest corporate FRNs are a more suitable investment vehicle for a ‘higher for longer’ rate environment.
1. Basel committee on Banking Supervision (2023), Basel 111 Monitoring Report.
2. As above - Basel committee on Banking Supervision (2023), Basel 111 Monitoring Report.
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