With European high yield spreads near their lows of the past decade, apprehension about valuations is understandable. However, any judgement of spread levels ought to be placed in the context of fundamental credit quality. The reality is that overall credit quality has improved a lot since the early days of the European high yield market.
European sub-investment grade bonds predominantly used to represent a subordinated layer of a borrower’s capital structure that resided between senior bank debt and equity. In other words, in the event that the issuer ran into trouble, bondholders would be paid after senior bank loans but before shareholders. The ratings they incurred reflected this status too. Over time, however, European high yield has become a predominantly BB rated market, transformed by two long-term shifts. First, the market has absorbed a larger share of fallen angels (former investment-grade issuers) with unsecured bonds that rank on a par with bank debt. And second, the market has seen an ever-higher proportion of secured bond issuance (bonds backed by specific assets of the borrower).
In 2000, only 5% of the European high yield market consisted of secured indebtedness, whereas over 40% of the market is secured today. This improved quality has implications for cross-asset-class valuations. For instance, it used to be conventional wisdom to move one’s leveraged credit allocations from high yield bonds into leveraged loans when high yield spreads were deemed to be rich. Leveraged loans were, after all, secured, which means they typically enjoyed maintenance covenants and ranked senior to a borrower’s subordinated bond liabilities. Hence, loans were considered the up-in-quality trade.
As this month’s chart demonstrates, the times have changed. While the European high yield market’s composition has become predominately BB rated over time, as the market has become more secured and less subordinated, the loan market has become predominantly single B rated, driven by an increased tolerance for higher amounts of secured leverage and the disappearance of maintenance covenants, among other factors.
As well as cross-asset-class considerations, the difference in ratings between the two markets also has implications for default rates and recoveries. Even if you do not love European high yield spreads at current levels, you can rest assured that valuations reflect the market’s status as the high-quality leveraged credit market.