UK consumer caution bad for growth, but good for bonds
European high yield spreads have tightened significantly since the beginning of Q4 2022, driven by clarity on a number of macroeconomic factors that were influencing markets in 2022. These include headline inflation peaking in Europe, the growing perception that central banks are close to reaching terminal policy rates, and China reopening its economy, among others.
Alongside this improving macro picture, which has sparked numerous upgrades to projections for 2023, corporate fundamentals have also remained extraordinarily robust, with many metrics pointing to record strength in the European high yield space. With this being the part of the ratings spectrum from which the vast majority of defaults historically occur we always keep a close eye on the evolution of these fundamentals from quarter to quarter, but they are of particular importance at the moment given corporate fundamentals inevitably start deteriorating once the economy feels the full force of monetary policy rate hikes.
In assessing how bad the situation might get for corporates, the starting point is crucial. While Q4 2022 earnings have only recently started to ramp up, we have a full set of data for Q3 2022 as well as full-year default rate stats.
For high yield issuers in Europe, gross and net leverage declined in the third quarter with the median measures (according to Morgan Stanley) now at 4.1x and 2.8x respectively (-0.3x and -0.4x year-on-year), driven by EBITDA growth in the 12 months to Q3 2022 of 23%. Net leverage remains at the lower end of the historical range.
Balance sheet cash as a percentage of debt rebounded to a record high of almost 30%, well above the longer term average of around 19% going back to 2003. Interest coverage (using EBITDA) also rose to a record high of 6.5x, approximately 1.5x above the level seen in the third quarter of 2021. This is in spite of the significant increase in yields, and driven by low refinancing needs across the sector given a record year of issuance in 2021.
All of these factors helped keep default rates lower than even the more bullish end of forecasts for 2022; European high yield saw a default rate of just 0.4% in 2022, the lowest annual figure in data going back to 2004, according to JP Morgan.
It is important to not get too optimistic about data that is inherently backward-looking (Q3 2022 leverage estimates, for example, will include EBITDA data from the Q4 2021). It does however point to the ‘buffer’ we see built into corporate high yield balance sheets at the moment.
While we expect the default rate to rise, we think the drivers listed above will see defaults remain below the levels we have seen in previous recessionary cycles.