European High Yield: forward looking expectations

November 09, 2022

Weakening growth, inflation and policy tightening continue to impact economic markets globally, yet European High Yield has been on an improving trajectory over the last two decades.

The drawdowns in 2022 have been substantial and have meaningfully reset valuations of European High Yield. The key investment question for our portfolios is whether this has sufficiently offset the building pressure on corporate earnings that we expect to cause an increase in credit stress and default loss, with defaults clustering thanks to earnings stress and credit availability.

However, with a strong starting position and capital rich banks, our perspective is that it will take a lot of economic stress to generate a pickup in defaults that surpasses a reversion to long term averages of 2-4%. Factors to consider include;

  • The more insidious long-term challenge to cash flows from a regime change on funding costs - with limited maturities and largely fixed coupon debt this is a multi-quarter or even multiyear process, and our current trajectory will create pressure into H2 2023 and 2024.
  • Governments are again taking away tails from consumers and to some extent corporates with substantial fiscal support to mitigate the impact of elevated energy costs. This is suppressing earnings shocks and defaults, which is good news for high yield investors.
  • European high yield valuations are trading at a discount to US high yield, as markets have priced in the higher probability of a deeper recession for Europe compared to the US. As there is no quick fix to Europe’s higher energy costs, the relative valuation between both markets remains justifiable but, in our view, will at some point offer a compelling opportunity when current headwinds began to ease.

Spread differential of European B-Rated High Yield - US B-Rated High Yield over the last 10 years

Source: ICE BofA, as at 31 October 2022. Note: 1 European High Yield refers to ICE BofA Single-B European High Yield Index (HE20) and US High Yield refers to ICE BofA Single-B US High Yield Index (H0A2) using LIBOR OAS

Regardless of an investor’s view on the forward path for the asset class, we believe that we have reached valuations that have historically generated compelling returns on a three-year horizon, even if spreads widen further. While moving into a recessionary period will lead to a deterioration in the operating performance of the companies we cover, credit metrics are at a decent starting point and the lower levels of primary-market issuance remain a positive technical for the asset class, which reflects the lack of need to refinance for most issuers.

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