The beginning of 2024 saw a revival of interest in the high yield asset class with investors starting to acknowledge that European High Yield (HY) starting yields are still attractive in the face of a benign default outlook and potentially falling rates, and a more meaningful shift in external flows could be what ends up surprising markets in 2024. 

This piece will focus on a review of what usually drives returns in the HY asset class: the state of credit fundamentals, technicals as defined by the balance between supply and demand, and finally valuations - how to extract value in a tight spread environment.

At the start of the year, our own FIL house view slashed the odds of a cyclical recession from 60% to 35%, and elevated Soft Landing to a base case with a 45% probability. Given this volatility of macro expectations, and the growing consensus that the ECB might be the first central bank to start cutting rates, many market participants have started to turn their attention to European High Yield again. 2023 saw returns of 12% for our asset class. Could we see 2024 replicate last year’s “shine”, or is rain looming over the horizon? 

The debate around the number of ECB cuts and timing of these is what the market heavily focuses on, but if there is one thing that we have greater confidence in is that the central bank is done with hiking rates, and that the European economy has managed to avoid a severe recession. This combination of factors is often a good environment for HY companies to perform, especially when the starting point of fundamentals is as structurally stable as it is today. Our universe is BB dominated and secured issuance has increased significantly in recent years (see chart 1). At the same time starting leverage and interest coverage ratios remain healthy, a ratings drift has been positive for the last couple of years and upcoming maturity walls are manageable. Finally, defaults, even though they are expected to increase somewhat, will not come anywhere near levels of previous cycles (see chart 2). There will be plenty of dispersion in our market as issuers grapple with higher interest costs, but the negative outliers are much more visible in a fundamentally sound market, and with diligent credit selection these should turn into alpha opportunities for active funds such as ours.

Chart 1: Universe is dominated by BB rated and secured bonds

Chart 2: European High Yield defaults and distress ratios - still below average levels

Our asset class often moves on the back of technical factors, with spreads usually supported when supply is lower than demand, which was a feature of 2023. We do not anticipate much of a change in that over 2024, with a moderate amount of supply but potentially more money chasing fewer deals. The overwhelming majority of deals that come to market though are for refinancing purposes, which is beneficial to investors: there is often capital upside associated with them, they remove short term liquidity risk for the issuer, and coupons get reset higher which bodes well for future returns (see chart 3).

Chart 3: The revival of the coupon supports the income component of total returns

And on to the trickiest of questions - how do you extract value in a relatively tight market? In spite of a challenging 2023 for government bond markets there has been little respite in the grind in European HY spreads, and many argue how much tighter we can go from here. It’s worth remembering however that the stellar returns of 2023 did not mainly originate from spread tightening, and most of the value in HY at the moment comes in the Yield, and not the Spread (see chart 4). Here at 6.2% we are still materially cheaper than 10-year averages in EHY and with central banks talking about a rate cutting cycle, there is still a reasonable enough case for investors to be trying to lock in current levels of yield while they still can, as they may not be around for long! 

Another logical, if somewhat optimistic viewpoint is that tight spreads per se matter less when a) cash prices are still very low - average cash prices in HY now at 93 cents are still well below par and historical averages (see chart 5), improving the convexity profile of the asset class and the proverbial “pull to par”, and b) bonds are indexed to worst yields but most HY bonds are coming out one year or more ahead of maturity, increasing the realised return. Bottom line, markets may be seen as expensive from a spread perspective, but the all-in-yields on offer should still result in attractive risk-adjusted returns to investors.

Chart 4: Spreads adjusted in 2023 but yields still remain attractive

Chart 5: HY prices well below historical average

Our 23 years of experience in managing European High Yield at Fidelity has taught us over and over again that it’s not about a directional bet on the market but rather a smart stock selection that rules in the end, and this will continue being our focus for 2024.

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