European high yield: Still a compelling investment opportunity

The outlook for returns on European high yield corporate bonds this year has been partially constrained by the record-breaking performance of markets towards the end of 2023. In the previous months, credit spreads have narrowed significantly to their tightest levels in 2 years.

Notwithstanding this impressive rally, all-in yields for the asset class remain at historically elevated levels. We have to go back as far as the height of the eurozone sovereign debt crisis in 2012 to find a time when European high yield last offered yields in the range of 6% to 8% for a sustained period. In combination with other factors, we believe the market still presents a very attractive investment proposition, especially when compared to its larger US counterpart.

Recent economic data such as corporate earnings statements and, in particular, the inflation outlook, point to a soft landing or mild recession in Europe, with downside risks centered around some of the more cyclical sectors of the economy. However, technicals remain strong and this year we expect to see limited net new issuance in European high yield combined with strong investor inflows. As a result, we currently believe the market could deliver high single-digit returns for 2024.

While we expect fundamentals to remain under pressure amid a general macroeconomic slowdown – with credit metrics likely to be impacted by refinancing taking place at notably higher coupons – we forecast defaults for European high yield to be lower than 2023 at 3.0%. Many corporate issuers in Europe have taken advantage of suppressed rates in recent years to extend maturity schedules. This should help defaults not only to remain below long-term averages but also serve to keep them at lower levels than in the US market, a trend that has continued for some time now.

Other factors that currently lead us to favor the European over the US market include a better average credit rating, higher credit spreads, and a more defensive sector composition. This is highlighted, for example, by the fact that Europe has substantially lower exposure to energy or technology issuers than the US has.

Looking beyond 2024, we do not believe the maturity wall presents a significant challenge in Europe given its skew towards higher-quality issuers, which typically do not have problems in refinancing. In addition, these issuers are supported by investor demand that has generally remained strong. By way of context, some 80% of 2025 maturities and 56% of 2026 maturities are BB rated. In comparison, around half of all high-yield bonds maturing over the next two years in the US are from lower-quality issuers rated B or CCC.

The combination of these factors means the investment case for European high-yield corporate bonds remains compelling. We expect the European market to deliver full-year returns of between 5% and 7% for 2024. After taking hedging costs into account, this represents a highly attractive return of 2.5% to 4.5% for Swiss franc-investors.

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