The high yield market in Europe has performed strongly in the first eight months of this year, in line with a recovery in corporate earnings and a very subdued default backdrop. The European High Yield Index has returned 3.8% to the end of August, with strong spread compression across ratings bands resulting in CCC-rated returns of almost 10%.
Spreads have tightened considerably since the peak of the pandemic, but they remain slightly wider than pre-pandemic levels for the main HY index and some way off the all-time tights (currently +75bps wide of the 2017 low using BAML EUR HY index vs Government bonds). We believe the support of the strong credit backdrop, combined with current valuations, will result in further spread contraction as the economic recovery continues.
Our conviction on this view is supported by a few key factors.
Most importantly, the default rate outlook remains very subdued. Contrary to our initial expectations at the beginning of the crisis last year, the fiscal and monetary support injected into the system has rapidly taken default risk out of the market. On an annualised basis the last six months has seen a Euro HY default rate of just 0.6%, and we expect the rolling 12-month rate to end both 2021 and 2022 at between 1% and 1.5%, below the 10-year average of 2%.
This is coupled with a growth outlook in Europe that remains solid. While the UK and the US have seen downgrades to Q3 growth expectations on delta variant fears, Europe has seen a relatively smaller impact as the vaccine rollout progresses rapidly and restrictions continue to be lifted, and the EU’s pandemic recovery fund should also provide a significant tailwind to growth over the medium term.
Additionally, we do not expect Eurozone inflation to reach anywhere near the levels seen in the US. Christine Lagarde and the ECB’s governing council recently amended the formulation of their policy objective, calling for inflation to be 2% well before the end of their projection horizon and “durably for the rest of the projection horizon”. While we acknowledge the recent spike in European CPI to 3%, a large percentage of this was driven by one-off and base effects; market expectations are for inflation to fall below the governing council’s target by the first quarter of next year, and to remain below 2% in the coming years. We think therefore that rates are well anchored at current levels and that the ECB will remain ultra-dovish, though we do think it could trim the extraordinary levels of PEPP purchases before the end of the programme in March.
Finally, from a bottom-up perspective, corporate earnings continue to be very strong, and we expect this to be reflected in further upgrades to corporate credit ratings in the coming 12 to 18 months. In the seven months to July, Euro HY saw €40bn of net upgrades – the fastest start to an upgrade cycle on record. Less than 50% of COVID-triggered downgrades have been reversed year-to-date, however, so we expect this record upgrade cycle to continue at a rapid pace.
Despite the impressive returns of Euro HY over the last year or so, the backdrop for the asset class continues to suggest there is more upside to come.