Sandrine Soubeyran
Robin Marshall
- Euro High yield (HY) credit has proved the asset class that defied the business cycle.
- Euro HY outperformed despite a mild recession, and rising rates.
- Low default rates, disinflation, renewed risk appetite and short HY duration all contributed.
- Central bank liquidity support pledges helped HY financials after the March banking crises.
Euro high yield (HY) credits have outperformed Euro investment grade (IG) corporate bonds, and those of other regions, both in July and since the beginning of the year. The FTSE Euro High Yield Bond index was up 1.3% and 6.5% respectively in July, and year-to-date, compared to 1.0% and 3.4% for the IG equivalents, while credits in other regions were modestly higher or lower. So why did Euro high yield credit outperform, and can this outperformance continue?
Chart 1 shows Euro high yield bonds have followed Eurozone equities higher over the last twelve months, with much of the increase seen since Q2 2023, while the performance of investment grade corporate bonds was more subdued. Credit rallied for a number of reasons, renewed optimism over early central bank pivots, more confidence in a soft landing for growth and inflation, low default rates and increased risk appetite.
Also, both the US Fed and Swiss SNB intervened to calm markets, and reduce systemic risks, after the collapse of Silicon Valley Bank, and Credit Suisse in Europe, upgrading depositor protection, and providing emergency liquidity. The Swiss authorities’ decision to “bail-in” Contingent Convertible bond holders, or Cocos, added pressure on high yield debt markets since equity holders in Credit Suisse were treated more favourably than Coco bondholders in the resolution. But contagion has proved limited, helped by higher Eurozone bank Tier 1 capital ratios.
Chart 1: Euro HY follow European equities higher, unlike Euro IG corporates.- Eurozone HY, IG and equities performance (TR)
Source: FTSE Russell, -12M as at August 1, 2023, total return, in euro. Past performance is no guarantee to future results. Please see the end for important disclosures.
The FTSE Euro high yield bond market has a sizeable exposure to banks (12%) and with other financials, they account for a weight close to 20% as Table 1 shows. Moreover, the next two largest industries, manufacturing and services represent a weight of over 20% and 25% respectively. While manufacturing has slowed within the Eurozone, services have remained robust, underpinned by post-Covid recoveries in consumer demand in sectors like tourism and travel.
Table 1: Banks, services and manufacturing represent over 60% of the Euro HY credit market.- Euro HY % largest sector exposure
Source: FTSE Russell as at July 31, 2023, total return, in euro. Past performance is no guarantee to future results. Please see the end for important legal disclosures.
Shorter duration has also offered investor protection in high yield indices
High yield credit issuers are rarely able to borrow in longer maturities, so HY indices tend to have shorter duration than IG indices. HY index duration proved volatile in the early days of Covid, as HY credits first fell sharply in price on risk-aversion and default fears, before rallying after the ECB began QE programmes, and eased financial conditions through its bank LTROs.
Overall, as Chart 2 illustrates, the effective duration for the FTSE Euro High Yield Bond index fell from about four years in 2020 to close to its pre-Covid level of about three years. But HY issuance in Euros has been generally very low since Covid, as companies have often substituted bank finance, at more favourable terms. The maturity profile and duration of Eurozone HY debt has also shortened as a result.
Chart 2: Euro HY Effective duration returns to pre-Covid level.- Euro HY effective duration
Source: FTSE Russell as at July 31, 2023, total return, in euro. Past performance is no guarantee to future results. Please see the end for important legal disclosures.
A further breakdown of the Euro HY performance across the curve shows yields declining in most maturities over the last year, with the 5-7-year section dropping the most, from 8% to about 6%. Even so, yield levels for Euro HY are still high, and higher than during the Covid spike. Only the 1-3-year area, which was close to 11% has fallen to about 8%. The longest part of the curve, the 10-year plus, while stable over the last twelve months, has seen the least yield compression since 2020 (Chart 3).
Chart 3: Euro HY yields have eased over the last 12 months.- EHY yields (%)
Source: FTSE Russell as at August 1, 2023. Past performance is no guarantee to future results. Please see the end for important legal disclosures.
Despite the higher yields, credit defaults, while rising, have remained relatively modest this year. According to S&P Global Ratings, the number of defaults in Europe fell from seven to six since January[1]. Meanwhile, European default rates are expected to rise “to 4.25% in the US and 3.6% in Europe by spring 2024”[2], notably in the more speculative end of the market. However, comparing and projecting default rates with previous credit cycles may not be a reliable metric, given that default rates are also driven by covenants within bond prospectuses, and investor protection covenants have tended to weaken since the GFC.
Credit quality of HY indices has improved as share of BB-rated securities increased
Looking instead at the performance of different rating buckets within high yield, lower rated CCC securities have underperformed, as Table 2 shows, and much of the positive performance came from the higher quality BB-B securities, which make up 76% of the FTSE Euro High Yield Bond index exposure. The higher share of BB-rated securities in HY indices reflects the impact of rating downgrades, in some cases “fallen angels”, which have migrated from IG to HY. But this has improved the overall credit quality of HY indices.
Table 2: Banks, services and manufacturing represent over 60% of the Euro HY credit market.- EHY performance by credit rating (EUR)
Source: FTSE Russell as at July 31, 2023, total return, in euro. Past performance is no guarantee to future results. Please see the end for important legal disclosures.
[1] S&P Global Ratings: Credit Market Research | S&P Global Ratings (spglobal.com).
[2] S&P Global Ratings: Credit Conditions | S&P Global Ratings | S&P Global Ratings (spglobal.com)
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