European high yield makes strong start to 2024 with default rates lower than expected

Last year saw returns in European high yield (HY) of approximately 12%, driven by tighter spreads (-102bps) and lower government bond yields (five-year bunds were -59bps). Defying expectations, strong balance sheets, coupled with low refinancing risks, also helped keep default rates low at ~2%, up from very low levels in 2022 (~0.5%). 

With maturity walls moving closer in a subdued growth environment (Germany is arguably in a recession), one could argue that there are other areas of the credit market that look more attractive on a relative value basis, as we have highlighted in the past, with financials and ABS as examples. 

However, there are a number of fundamental and technical factors that underpin HY, which have continued to drive outperformance in the sector versus rates and other credit markets. Indeed, the 25bps move tighter in pan-European HY last week was the biggest weekly move in percentage terms since the start of 2021, according to Barclays. 

From a technical perspective, flows over the past three months have been materially positive (~5% of assets under management) at the same time that net issuance has been negative. With cash balances that were already high, and with January being one of the best months of the year for coupons and maturities, HY managers have to deploy that cash somewhere, particularly in an improving macro environment. 

The question is where? Well, with metrics pointing to defensive positioning going into 2024 (beta is in the 50th percentile), the trend so far has been a “grab” for beta. For example, CCC bonds saw double the spread move tighter last week compared to the index (while still leaving the average CCC rated credit at 1000+bps), with sectors that underperformed last year (like real estate investment trusts) significantly outperforming this year. With BB spreads that are in the ~20th percentile post-GFC, we can see this compression continuing to play out in the coming months, although if flows turn weaker (or net supply beats expectations) that might be a bearish compression (i.e. BB selling off) rather than a bullish one.

From a fundamental perspective, balance sheets continued to improve through 2023, with median net leverage ticking down in the third quarter to 3.15x (-0.22 quarter on quarter), inside the post GFC average of 3.53x, while median interest coverage remains ~0.7x above the post GFC average, although -1.4x below the peak at the beginning of the 2022. Cash balances remain elevated at ~24% higher than the post GFC average, while Ebitda margins over the last 12 months are ~110bps higher than the longer-term average at 15.9%. 

While the much talked about maturity wall in 2025 will have to be addressed this year, given the technical and fundamental backdrop just described, we expect this to be relatively well absorbed, particularly given the vast majority of that refinancing risk is in BBs. Given the rally in higher beta credit so far this year, the refinancing risk of lower rated credits has also declined, and the single B 2025 refinancings that came at the back end of last year (EG Group and AMS, for example) are all trading well above par (107 and 108 for the two just mentioned). 

Ultimately, while we believe default rates are likely to continue moving upwards this year, the pace at which this takes place might be slower than previously anticipated with a 2% to 3% default rate looking increasingly likely. Now, it is worth mentioning that we are not recommending investors move down the capital structure and start buying CCC rated credit. The outperformance this year has come after significant underperformance last year (the CCC index returned ~5.1%, -690bps below that of the HY index), and while the macro environment has improved, we still remain late cycle and exposed to macro shocks. 

We do, however, think the likelihood of a significant deterioration in credit is low at the moment, and so absent a sharp drop in growth and a large rates rally we think credit can continue to outperform rates and spreads/defaults will continue to remain relatively well anchored as we move through the first few months of this year.