In order to derive some investment conclusions, I will take a brief look at history of the 1930s US.
The effects of the banking crisis in the 1930s on the bond markets
Source: St. Louis Federal ReserveFor the corporate bond yields I used the Moody's seasoned indexes which try to include bonds with remaining maturities as close as possible to 30 years. During the banking crisis in the early 1930s - and similar to what we saw last year - government bond yields were moving sideways to lower whereas credit-related yields were shooting higher, aggravating the banking crisis. Credit yields peaked in mid 1932 before entering a multi-year downward trend. Credit spreads showed the same behaviour as the chart below shows. This is remarkable as the recession lasted from August 1929 until March 1933. In between, the spread between Baa and long-term government bond yields had fallen from a peak of almost 800bp in May 1932 to a low of 420bp in autumn 1932 before rewidening temporarily. However, in 1932 real GDP collapsed by roughly 13% and fell by another 1.3% in 1933. Furthermore, even though growth rose to 10.9% in 1934 and 8.9% in 1935, credit yields continued to trend lower.
Corporate bond spreads entered multi-year downward trend following the banking crisis
However, what the above charts also shows is the huge volatility in the Baa yields and spreads vs. relatively stable AAA yields and spreads. Furthermore, there is a significant discrepancy between the AAA and Baa yields going into the next recession which started in 1937. AAA yields briefly moved a bit higher ahead of the recession but soon moved back on the path to lower yields.
Multi-year downward trend only briefly interrupted by onset of next recession for AAA bonds
On the other side, Baa yields once again moved significantly higher also starting a bit ahead of the recession but moved higher during almost the entire recession!
More pronounced and longer-lasting rise in yields for Baa bonds
Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Italy, Austria and Belgium and be neutral on Spain (amid the poor fundamentals) as well as Germany and France (amid the lack of yield pick-up). On the other side I would be underweight in Ireland, Greece and Portugal amid poor fundamentals and a lack of liquidity despite the yield pick-up. Finally, I would continue to overweight covered bonds in general as well.