What is our view on fundamentals?
The European high yield market’s overall credit quality is strong. Not only is 67% of the market BB rated1, it has also benefitted from the absence of a typical expansionary phase of the leverage cycle as the Covid pandemic and Ukraine invasion forced borrowers to protect their balance sheets.
Additionally, as a fixed rate market, European high yield corporates’ borrowing costs have remained low despite the sharp rise in global yields, with the weighted average coupon of the European high yield market at just 4.0%2. While refinancing requirements will force high yield borrowers to pay more, credits with multiple maturities will only see their average interest costs move up gradually.
We believe the bigger threat to most borrowers’ debt service ratios is the trajectory of forward earnings rather than interest costs, but the overall credit quality of the market and the lack of a typical pro-cyclical leveraging cycle should support credit quality through any earnings downturn.
There is a looming wall, but the risks are overrated
What will drive default rates in 2024?
One of the most frequently cited fundamental fears investors have expressed about the European high yield market is the so-called "maturity-wall". At present 44% of the market will need to be refinanced by the end of 20263.
The principal reason for the maturity wall's existence is that issuers have chosen to hold onto their low coupon debt for longer as it makes less sense to call their debt early in a higher interest rate environment.
Furthermore, 65% of debt maturing over the next two years is rated BB3 and therefore should have little problem accessing bank or bond markets in order to refinance.
Nevertheless, there are high yield issuers whose current yields in secondary markets suggest that they will struggle to re-borrow, and as a result, defaults would be expected to rise from today’s low levels. Our expectation is for European default rates to peak at roughly 2.5% in the current credit cycle, an increase from last year’s low and slightly above the long-term European default average of 1.6%4. Within European high yield, we expect that the real estate sector will comprise the majority of any defaults.
Technicals were very strong last year. Will these conditions last?
Technicals arguably were the European high yield market’s most supportive factor in 2023 despite unremarkable flows into funds until the final quarter. However, low net new issuance and a slew of rising stars reduced the size of the market significantly.
2023’s primary issuance was mainly dedicated to refinancing existing debt. Combined with the absence of leveraged buyout-related issuance and mergers and acquisitions (M&A) activity, net new supply therefore was just €2.7 billion5. This supply is before counting the €18.3 billion5 from coupons that came back to investors during the year.
This year’s supply is expected to underwhelm as well, as we anticipate the majority of bond offerings will continued to be used to roll existing bond maturities. We do not anticipate the same volume of rising stars, but given our expectations for a long-awaited resumption of inflows, this hardly seems to matter.
Rising stars and low net issuance more than offset muted flows in 2023
Is there any value left in European high yield?
Having rallied into the end of 2023, European high yield spreads currently sit close to their 10-year average, but remain at a sizeable discount to the lower average credit quality US high yield market. Furthermore, this historical spread comparison needs to be adjusted for the extraordinarily short duration (3.6 years to maturity vs. the 10-year average of 4.8 years) and low cash prices (91.5 vs. 99.3 10-year average) of the current market6.
Finally, all-in yields sitting in their 85th percentile over the previous 10 years are still high6. The combination of low duration and high yields means that it would require an approximate 230 basis point6 move higher in yields to negate current annualised carry on the index.
Can spreads move tighter this year?
Within European high yield, dispersion has started to pick up. The underperformance of CCC rated bonds last year means they screen as wide to single-Bs as they have at any point over the past decade. However, it is important to note that a significant portion of CCC and headline spread levels are coming from deeply distressed situations, such as real estate. We believe that if more of the market becomes comfortable with the soft-landing outlook, we will see investors dip into lower quality names/sectors.
