After a strong start to the year, European High Yield bonds experienced a period of volatility caused by the regional banking crisis in the US and the demise of Credit Suisse. High Yield spreads widened markedly in response but have since tightened considerably as investors regained their poise. Attention has shifted back to the potential problems concerning the impact of rising rates, higher inflation and a weak economic outlook. Despite these headwinds, we remain broadly positive on European High Yield bonds. Here, we explain why.
The yield available more than compensates for the risk
As at the end of June 2023, the European High Yield market offered a yield-to-maturity of 7.53%, which we believe rewards investors for the risk they are taking. Approximately 40% of the yield is derived from the underlying European government bond yield curve. As such, a significant proportion of the overall exposure is to secure European government bonds. The other 60% of the yield is comprised of the credit spread – this is the additional return sought by investors to lend their capital to companies as compensation for the risk that they might default on their debt.
Currently, this spread is around 4.46% and well above the 10-year average of 4.05%. In our view, the additional return more than offsets the current default outlook, as predicted by Moody’s. Its 12-month forward-baseline predicted default rate is 3.80%, slightly lower than the long-term average of circa 4.0%. We believe Moody’s is being slightly pessimistic. We forecast that the actual default experience will be more benign. Investors should also consider the recovery rate in the event of a company default, which has historically been around 50%. This reduces the impact on returns to nearer 2%, should Moody’s forecasts prove accurate.
Then there’s the economy. If it does fall into a mild recession, central banks will likely cut interest rates and government bond yields will fall. This will boost investors’ returns due to the capital gain provided by the underlying duration sensitivity. Given these factors, we’re confident that European High Yield will provide positive returns over the medium term.
Extended maturity debt profile
Companies took advantage of the relatively attractive cost of finance just before and during the Covid-19 pandemic to extend their maturity profile. During 2019-2021, companies refinanced debt totalling some 80% of the entire market value, locking in low coupon rates of below 4%. That means there’s no imminent ‘maturity wall’, where a large proportion of bond issuance in the market is due to mature and those affected issuers are compelled to refinance at potentially much higher prevailing interest rates. In fact, less than 20% of the market will mature by the end of 2024, with the bulk of maturities coming in 2026.
This provides some breathing room, allowing companies to wait until central banks have completed their hiking cycle and for the cost of financing to be potentially lower than current elevated levels.
We believe the yields on offer more than reward investors for the risk they are taking.
Company fundamentals are good, though caution is required
European companies are in relatively robust shape. The economy appears resilient, unemployment is low, and the consumer is still spending – which has maintained corporate profitability. Company balance sheets are not stretched, while closely watched metrics such as leverage and interest cover are within comfortable levels.
However, there are signs that higher interest rates and elevated inflation are causing stress in certain sectors of the market. Companies without pricing power to pass on higher input costs or industries that have only managed to survive due to cheap financing may struggle. The market will differentiate between the strong and the weak. It will therefore be important that you fully understand the companies to which you’re lending capital. We believe an active management approach can add significant value in this environment.
European High Yield compares favourably to US High Yield
The European High Yield market has a lower risk profile than its US equivalent. It could therefore be the better option if we’re heading for some economic turbulence. On average, the European market is one notch higher in credit quality at BB- compared to the US rating of B+. According to Moody’s, the European market also has a more favourable predicted 12-month baseline default rate of 3.8% versus the US at 5.6%.
You would expect this higher risk profile to be reflected in prices – however, the US credit spread is relatively tighter. The US market ‘only’ offers investors a credit spread of 4.05% compared to Europe’s 4.46%. This imbalance is reflected across the entire rating spectrum from BB down to CCC. In its defence, the US market has a higher yield-to-maturity at 8.6% – although this is mainly due to the higher yield available from underlying US government bonds.
The investment environment has been resilient so far in 2023. Some investors predict a marked economic slowdown due to tighter monetary conditions. Others believe central banks can deliver a soft landing and avoid recession. Whichever scenario prevails, European High Yield, with its balance of credit risk and duration sensitivity, could deliver positive outcomes for investors over the medium term.