European High Yield funds post record inflows amid buoyant investor demand

A lot has happened since our last blog about the state of affairs in the European High Yield (HY) market. At the time, the sector had just seen three of the largest capital structures of Altice France, Ardagh Group and Intrum AB announce restructuring advisors in quick succession, with growing fears that it would represent the start of a wider default trend.

Since then, the HY space has experienced two notable bouts of volatility. First in early June, when a snap parliamentary election called by French President, Emmanuel Macron, led to bonds of French issuers to come under heavy selling pressure as political uncertainty mounted. Then, two months later, the significantly weaker than expected US labour report sparked fears that the global economy could be entering a hard landing; a scenario particularly detrimental to higher risk corporates such as those found in the HY space. Under normal market circumstances, one would expect these events to have a prolonged impact on the HY sector, with credit spreads remaining elevated for an extended period of time given reduced demand for risk-on paper. However, the still strong corporate fundamentals, in addition to a highly supportive technical environment, resulted in spreads rebounding remarkably quickly, off the highs on both occasions.

The strong technical we have been noticing made headlines on Friday when it was reported that the period from 10-16 October saw the largest absolute weekly inflow into Pan-European HY funds since data was first recorded in 2005 at +€1.5bn, based on JP Morgan data. The figure also represented the largest weekly inflow as a proportion of European HY assets under management since 2016, with the inflow driven predominantly by exchange-traded-funds (ETFs). This follows a healthy €8.8bn of net inflows into European HY funds year-to-date (YTD). This is strong evidence that flows into HY (and other risky assets) can accelerate even if spreads are below their long-term averages. While this, by no means, translates into us being more positive in B-/CCC cohorts, we do think that broad sell-off episodes are likely to be relatively shallow as bids emerge quickly to buy the dip.  

Despite technical tailwinds evidently contributing to persistently tight spread levels, the credit strength that European HY corporates have displayed has also played a pivotal role in keeping a lid on any potential widening so far this year. The 12-month trailing HY default rate stands at just 2.71% in Europe, as corporates continue to prove their ability to navigate the challenges of rising interest costs associated with the higher rate environment. Distressed debt (defined as debt trading wide of 1,000bp) now only accounts for a 6% share of the overall European HY market, representing the lowest level since May 2022 and facilitating strong total return performance of +7.3% YTD. The sharp uptick in supply we have been seeing of late is likely a direct consequence of the credit strength issuers have been demonstrating. Q3 saw €26bn of non-financial HY supply in Europe and these next couple of weeks are likely to bring another wave of issuance as corporates look to come to the market before the US presidential elections. Eight deals totalling €4.1bn have already launched this morning. The sharp uptick in leveraged buyouts (€6.3bn across six separate deals in the third quarter alone) and dividend recapitalisations in recent months, including what we believe is the largest dividend recapitalisation deal in recent HY history from Belron at €4.4bn, is undoubtedly also linked to the underlying credit strength and investor confidence displayed across the space. This has allowed some of the more problematic credits to address their upcoming maturities and break down their respective maturity walls that had caused concern among investors this time last year.  

Now, we continue to remain cautious of lower (CCC/B-) rated capital structures typically characterised by elevated leverage figures, skinny levered free cash flows (LFCF) and volatile earnings profiles, with certain data trends already exhibiting signs of deterioration. The six-month annualised default rate, for example, rose to 4.2% in September, a meaningful uptick from March’s 1.3% level and historical averages which sit in the 1.7-2.0% range. Average interest coverage ratios (ICR) and net leverage figures amongst more vulnerable HY corporates have also continued to weaken in recent quarters as the higher rate environment takes its toll, although fundamentals across the sector as a whole remain solid, with net leverage in the middle of the ten-year range and interest coverage above. We expect the rolling 12-month default rate to remain around 3% as we move through 2025, supported by sluggish but positive real GDP growth and European Central Bank (ECB) cuts as inflation continues to decline.

For now, the European HY market remains on steady footing and continues to offer attractive yield opportunities relative to both its US counterpart and its own historical averages. Technical and fundamental tailwinds are expected to keep spreads well supported, with attractive all-in yields and subdued volatility still driving solid returns. There are some areas of weakness in the space, particularly at the lower end of the quality spectrum, so we remain selective in our allocation to the European HY market however, continuing to find better relative value in both financials and Asset-Backed Securities (ABS).