As the world faces challenges from weakening growth, inflation and policy tightening, the good news for European High Yield investors is that the underlying strength in the asset class has been on an improving trajectory over the last two decades:
- In the early 2000s the asset class risk profile was dominated by smaller companies at an earlier stage of their business plans. Particularly the tech boom brought roll-out cable operators with high capex with revenue pay-offs which were several years away.
- In 2005-2008, pre–Global Financial Crisis (GFC), high yield markets were the key financing route for junior risk in LBOs; CCC supply increased bringing businesses with more precarious balance sheets into public markets.
- The index now has more mature multi-national companies whose balance sheet vulnerabilities are offset with more dependable cashflows. Across multiple sectors there are national champion brands such as Media, Chemicals, Automobiles, Telecommunications and Banking.
- For investors this is a noticeable improvement since the GFC, with the proportion of BB rated credits over 70% in Europe compared to 53% at the end of 2008.
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. Defaults cluster because the two key inputs are earnings stress and credit availability. These are correlated factors, but with a strong starting position and capital rich banks our perspective is that it will take a lot of economic stress to generate a pick up in defaults that surpasses a reversion to long term averages of 2-4%.
The more insidious long-term challenge to cash flows comes from a regime change on funding costs that will take a long time to play out – with limited maturities and largely fixed coupon debt this is a multi-quarter or even multiyear process. There will be plenty of water to pass under the bridge in terms of economic data and activity, but 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 painfully elevated energy costs. This interventionist mindset supresses earnings shocks and defaults which is good news for high yield investors.