European high yield (HY) debt over the past years has emerged as one of the best performing assets within its class. The reach for yield quarter on quarter was one of the reasons why this niche sector continued to tighten and appreciate in value, in my view to ridiculous levels. In primis, the tightening was brought about by the wave of monetary tightening put forward by the European Central Bank (ECB), which in simple terms has created a situation of extra liquidity where investors continued to put money to work despite the risk of the asset class per se as well as the downside potential risk in valuations. Furthermore, the low interest rate scenario also triggered a wave of re-financing in the European HY debt market. Simply put, highly leveraged companies managed to borrow at absurd low rates, despite the risk of both operational and financial leverage. Lately we saw a notable widening in spreads, as bond prices fell. Is it time to dip in your toes?
As at yesterday, the ICE BofAML Euro High Yield index was offering a spread over the benchmark of 457 basis points, the highest level since April 2016, when we had experienced remarkable pressures in commodity prices. To put readers into perspective, one must point out that the said European HY index is highly skewed towards Italian debt (circa 15 percent), a region, which is being battered by political instability – thus a natural move of widening spreads, but also defaults in the construction sector. With the names of Astaldi defaulting, while CMC Ravenna announced the delay of its interest payment. The latter pressures have easily spread to other European HY issuers, namely in Spain. So yes, some sort of specific risk is one of the reasons for the recent widening.
In addition, the sensitivity to the recent market volatility cannot be unnoticed. Let us not forget that risky debt is highly correlated to equities and thus one can’t expect not to be pinched by the recent volatility. However, recently through my day-to-day analysis I have come across an interesting fact. Historically, European HY debt and U.S. HY debt have had a normal relationship, but the former generally has traded tighter than its U.S. peer. This comes to no surprise given the better quality in terms of ratings in European HY as opposed to U.S. HY. Today the situation has reversed and European HY is trading cheaper, a situation which is usually visible in times of distress.
However, one should put everything into context. It is a fact that U.S. growth prospects today are more favorable, this is visible through the more encouraging economic data prints and corporate revenues. That said, I’m not saying that European HY is heading towards a period of distress. In fact, recent data showed that on average leverage did increase as corporates took an opportunistic approach of the lower cost of funding, but coverage of financing has increased to 6.7x, the highest seen since 2004.
Definitely what has increased, and here there is room for judgement, is the volatility in single names. Lately we have seen a wave of unjustified volatility in names, which is at times unjustifiable as their financials indicate otherwise. To us Mangers, this anomaly puts unnecessary pressures, but this is the time when one should take the plunge and dip-in at more favorable levels as we have done this week. As my colleague, rightly so, pointed out in our morning market-related conversations, as opposed to the equity market, the HY market offers less visibility in terms of real trading levels. Given that we’re currently trading at the highest spread levels since 2016, I think the European HY market, selectively might have become more attractive in valuation terms.
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