Getting technical on European high yield

November 1, 2024

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In his latest column on the key developments, themes and opportunities in credit markets, Ian Horn examines the factors behind the consistent performance of high yield this year.

European high-yield (HY) credit spreads have proven remarkably resilient in 2024. This has been attributed to a supportive technical environment - increasing demand in a period of falling supply. Here, we explore some of the key reasons behind this dynamic.

A shrinking market

The European HY market has shrunk by almost 20% since the start of 2022, from €470 billion to around €380 billion (Figure 1). The main reason behind this is the mismatch between ‘rising stars’ (issuers upgraded to investment grade (IG) that have left the HY market) and ‘fallen angels’ (IG issuers that have been downgraded to HY).

According to a recent Barclays study, 2024 is set to be the fourth consecutive year in which rising stars have outpaced fallen angels.¹ This has resulted in a persistent net shrinkage of the HY market since 2020.

Year to date, the study shows €36 billion of bonds have left the European HY market as issuers were upgraded to IG, with just €21 billion going in the opposite direction after losing their IG status. In effect, the market has shrunk by 5% this year.

There are a couple of noteworthy points on the rising star cohort. Banks have represented a large portion - around €16 billion - with peripheral European banks in particular seeing positive rating action. Meanwhile, some high-profile issuers that were downgraded during the COVID-19 era have now returned to investment grade, including Rolls Royce and International Consolidated Airlines Group (IAG).

The list of fallen angels is smaller, with a single UK utility, Thames Water, representing 40% of the downgraded bonds (€8.4 billion). A handful of real estate names have also migrated down to HY as that sector has seen pressure on credit metrics.²

Increasing demand

Whilst the size of the market has contracted since 2022, demand has increased substantially through 2023 and 2024. Assets within European HY exchange-traded funds (ETFs) can provide a useful proxy for the growth in demand. Figure 2 shows assets in one of Europe’s largest HY ETFs.³ Since the start of 2022 - the period in which the market has shrunk by almost 20% - assets in this particular ETF have grown almost 60%.

CLOs further fuel demand

Besides inflows to dedicated HY funds, we have seen strong demand for HY bonds from European collateralised loan obligations (CLOs). The CLO market has grown strongly over the last few years, as investors sought floating-rate investments during the period of rising-interest rates as well as the spread premium associated with structured credit.

Figure 3 illustrates the growth of the European CLO market and bond ownership by these vehicles.

Reasons for caution

In summary, the technical environment for European HY has been particularly strong over the last couple of years, driven by a shrinking market and a surge in demand. Whilst we have seen signs of earnings pressure and credit deterioration in Q3 earnings, the technical dynamics should continue to be supportive of the asset class, in our view.

Nonetheless, as my colleague Thomas Samson noted in his article No time for complacency, caution is justified when questions are being asked on credit fundamentals and valuations, and technicals are the main driver of market strength.

In such an environment, we continue to express an ‘up-in-quality’ bias in our crossover strategies, currently preferring to take targeted risk within investment grade than in lower-rated credit. In our view, the changing opportunities between investment grade and high yield are also supportive of crossover strategies that can access both markets, taking risk where it is attractively priced.

References

1. Barclays FICC Research, ‘Macro Volatility vs Supportive Technicals,’ October 25, 2024
2. Barclays FICC Research, ‘Macro Volatility vs Supportive Technicals,’ October 25, 2024
3. Shares EUR High Yield Corp Bond UCITS ETF (IHYG LN)

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of November 1, 2024, and may change without notice.

 

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Index descriptions

HE00 - The ICE BofA ML Euro High Yield Index tracks the performance of EUR dominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million. 

ER40 – The ICE BofA ML BBB Euro Corporate Index is a subset of the ICE BofA ML Euro Corporate Index (ER00) including all securities rated BBB1 through BBB3, inclusive.

HE10 – The ICE BofA ML BB Euro High Yield Index is a subset of the ICE BofA ML Euro High Yield Index (HE00) including all securities rated BB1 through BB3, inclusive.

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