Fundamentals

Broadly we would still categorise European High Yield (EHY) fundamentals as fairly healthy, with JP Morgan’s last full quarterly (Q1-2024) survey showing median interest coverage at 3.7x and headline net leverage at 5x but BB leverage sub 4x. More recent earnings reports have also been broadly supportive. While there has been some softness in some areas (mainly packaging, chemicals, auto/industrials), there has been stability in telecommunications and strength in leisure, apparel and real estate. In larger capital markets like the S&P 500, there’s robust evidence of earnings growth continuing (Q2-2024 EPS up 12% YoY representing a 6% beat vs consensus). 

Chart 1: European High Yield Interest Coverage

Valuations

After the early August ‘summer sale’, when spreads widen to 400bps, the grind quickly resumed and we are now back at the tights in some spots. Crossover at 290bps is just 8bps off the year’s closing tights, while cash (index spreads) at 343bps are 30bps wider than the level they reached in early June. Cash has therefore underperformed crossover over the month of August, so there may be a little bit of illiquidity premium still in the cash market to be harvested.

Sentiment 

Sentiment to us feels relatively neutral. The majority of funds are clustered around an index-type return and there are several notable laggards to the index return this year. While mutual fund betas are less influential than in the past in terms of dictating market direction, we think it’s fair to say that there is unlikely to be an exit liquidity vacuum purely on the basis of current positioning. The lack of sellers in the first week of August might lend weight to that argument as well.

Supply 

While Investment Grade markets have been relatively busy, the High Yield supply calendar and outlook remain eminently manageable. We have recently had flagged to us around 15bn of Lev Fin pipeline of which 9bn likely to be bonds. Only about a third of that might be new money. There are 3-4 reasonable M&A deals in the pipeline for the autumn. All of these data points imply a fairly robust technical picture is likely to persist, though we do also hear of increasing interest in pre-funding ahead of the US election.

Idiosyncratic stories 

Idiosyncratic stories work on the upside too! Index (HEC0) returns in August were another ‘coupon clipping’ excess return of 0.7% but this month there were a number of significant upside movers, and single Bs actually had their best month of the year. After a year to date where all the focus in the HY community has been on distressed risk management, the last month has been a reminder that getting too bearish in stressed/distressed sectors can be painful as well! 

Real Estate

We still like the real estate risk cocktail here and are staying well invested. For a small sector in European HY (it only makes up around 5% of the market) it provides a large amount of DTS/alpha potential. It’s now a close second to our bank risk position in DTS terms. It’s curious, and perhaps a little too simplistic, that so much of the toxicity surrounding the space (governance, disclosure, related party transactions etc) have been forgotten in the ferocity of the rally. Correlations breaking is a key risk, but the dovish moves of central banks and inflation normalising are a promising backdrop in the context of valuations that are still wide and fundamentals that appear to have bottomed.

Risk warnings

• The value of investments and the income from them can go down as well as up so you may get back less than you invest.
• Funds are subject to charges and expenses. Charges and expenses reduce the potential growth of an investment. This means you could get back less than you paid in. The costs and returns of funds may decrease or increase as a result of currency and exchange fluctuations. When referring to sustainability – related aspects of a fund, the decision to invest should take into account all characteristics or objectives of the fund as detailed in the Prospectus.
• Past performance does not predict future returns.
• Reference to specific securities in this document should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. 
• Investors should note that the views expressed may no longer be current and may have already been acted upon.
• Bond investments: The price of an investment in bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may, therefore, vary between different government issuers as well as between different corporate issuers.
• Corporate bonds: Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds.
• High yield bonds: Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the investment in them.
• Overseas Markets: The value of an investment in overseas markets can be affected by changes in currency exchange rates. Please refer to the Prospectus and KID of a fund before making any final investment decisions.
• Currency Hedging: Currency hedging is used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made.
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• Derivatives: Investments using financial derivative instruments for investment purposes, may be exposed to a higher degree of risk and can experience larger than average price fluctuations.
• Other: Investments in European high yield bonds do not offer any guarantee or protection with respect to return, capital preservation, stable net asset value or volatility. 

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