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16 February 2023
The flight path for European high yield
Investors are now expecting a soft landing in Europe, resulting in tighter credit spreads over recent weeks. We examine what could happen next in the European high yield market.
Fundamentals
European economic data has held up surprisingly well despite the European Central Bank’s (ECB) continued rate hiking. A warmer-than-expected winter and elevated gas storage leading to lower gas prices have contributed to the improved sentiment and resilient economic data which has led the market to price in a soft landing as the base case. However, inflation may remain sticky for longer, indicating that the ECB’s work could be far from finished. The market’s optimism has run contrary to corporate fundamentals. Fourth quarter earnings, while far from a disaster, have been much more of a mixed bag. More concerning was the magnitude of downward revisions to analyst forecasts in January, ahead of published fourth quarter results. Besides adjustments in earnings, another area to keep an eye on are developments on default rates. Stricter bank lending conditions tend to be the harbinger of higher defaults. However, with more than two thirds of the European high yield (HY) bond market rated BB and a eurozone recession looking less likely to occur, it is difficult for us to see default rates peaking at more than 2.5%-3.0%.
Quantitative valuations
Yields remain attractive in absolute terms sitting at ~6.8% as of 14 February 2023, compared to ~4.0% a year ago. This has been driven by the rise in base rates and not by a rise in the credit risk premium. Spreads have continued to compress since the peak in September 2022 at around 650 basis points (bps) and for the first time since October 2021 are now trading inside those of the US HY market. At around 410bps, European HY spreads are at their two-year average but still well above their tightest level of 284bps during this period. Given fundamental headwinds, we think that these valuations are fair, but still cheap compared to the US market when adjusted for the higher duration and lower average credit quality of the latter.
All-in yields have remained high while spreads have absorbed higher rates
Source: Bloomberg, ICE BofA. Data as of 31 January 2023. EHY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index (HECM)
Technicals
Without a doubt, technicals have been the driving force of the rally so far this year. Investors have been covering their underweights to European risk assets after pulling more than €13 billion from European HY funds in 2022. Demand is not the only factor that is providing technical support to spreads. Supply remains scarce. Last year’s interest rate volatility resulted in European high yield net primary issuance touching historical lows. The market anticipated an uptick in new issuance that has underwhelmed expectations and pushed secondary prices higher. Lastly, as confirmed by third-party investor surveys and our by our own market beta monitor, active managers have in aggregate entered the year with less risk than their benchmarks. We expect at least two of these three technical factors to hold for the remainder of the current quarter, with little supply on the horizon and European risk asset valuations attracting continued flows.
What does this mean for investors?
The European HY market has performed well at the start of 2023 after a challenging 2022. Attractive all-in yields should continue to drive demand, but investors need to keep their eyes on spreads. Neither US nor European spreads are discounting much in the way of recession risk, but for investors looking to increase their exposure to high yield, Europe still looks good value to us.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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