The longest winning run for euro high-yield company bonds since 2021 is under threat as troubles mount for Europe’s riskiest borrowers.
(Bloomberg) — The longest winning run for euro high-yield company bonds since 2021 is under threat as troubles mount for Europe’s riskiest borrowers.
Euro-denominated speculative-grade debt has enjoyed six months of positive returns, according to a Bloomberg index of the notes, but the gains have been steadily reducing and have now slipped to a 0.6% loss so far this month. It’s setting the asset class up for its first monthly loss since March, when Credit Suisse’s collapse roiled global markets.
It follows a choppy few days for global markets, with a gauge of credit risk for European junk firms initially surging on Wednesday after the yield on 30-year US Treasuries breached the 5% mark for the first time since 2007. The gauge remains at the highest level since May, according to the Markit iTraxx Crossover index.
“There are fears that credit markets will experience a tough time in the coming quarters,” said Gary Dugan, chief investment officer of Dalma Capital, in an Oct. 2 note. “High-yield in particular looks vulnerable to downside risks.”
Global high-grade company notes have also slipped into the red amid expectations from some of the biggest names in debt markets that defaults will rise in the coming years. That’s as riskier debt comes due for refinancing, even if current default rates remain low for now. Fitch Ratings is among those warning of higher default rates for leveraged finance in 2024, citing continuously high interest rates and slower global growth.
See also: Franklin Templeton’s Cryer Awaits Wider Junk Spreads on Defaults
Higher rates for longer are “pretty terrible” for risk assets, Joshua Easterly, co-founding partner and co-president of alternative credit specialist Sixth Street, said at the Bloomberg Global Credit Forum in September.
Back to Reality
The rising yield backdrop is offsetting all other drivers of income for holders of corporate debt, in what is a snap back to reality for investors in euro high-yield notes.
Some advantages remain to holding the securities. That’s because euro corporate bonds tend to have a lower average duration than their dollar equivalents — that is, a reduced price sensitivity to changes in yields. The average maturity of bonds in Bloomberg’s euro high-yield corporate index is 3.65 years, compared with nearly five years for the dollar equivalent index, suggesting the latter are more likely to fall when rates rise.
“It’s fair to expect returns to turn negative as central banks stay higher for longer,” said Althea Spinozzi, senior fixed income strategist at Saxo Bank, in an interview. That’s because “the economy will tighten further, putting an enormous pressure on lower-rated bonds.”
Yet she favors euro high-yield, as the notes’ coupons are “still making up for any price weakness,” over equivalent dollar notes.
High-Yield Bulls
Others are also bullish on the notes’ performance through to year-end. A Bloomberg Intelligence survey showed 53% of respondents expect positive returns from corporate high-yield debt in the fourth quarter, while investors anticipating better returns in the asset class than for high-grade outnumber those expecting the reverse. Even so, nearly a third of the respondents are underweight euro high-yield.
“Corporate earnings and rate hikes are seen as pivotal for returns,” Bloomberg Intelligence’s Mahesh Bhimalingam and Heema Patel wrote.
In what’s been a subdued year for issuance of high-yield corporate debt in Europe, volume has reached about €62 billion ($65 billion), the second-lowest annual sales on record behind 2022, according to Bloomberg’s EMEA corporate high-yield bond league table dating back to 2012. It follows a record year for sales in 2021, when firms seized on a variety of sentiment-boosting central bank tools, including asset-purchase programs and interest rate cuts, to raise a record amount of debt.
To be sure, euro high-yield firms’ spreads have been range-bound between about 400-450 basis points since the summer. Barclays Plc strategists led by Craig Nicol expect them to stay there through to year-end assuming no macro surprises, according to a Sept. 22 note. “Valuations with respect to spreads do not look hugely different versus where they were at the end of June,” they said.
They’re more optimistic on the returns outlook, because the mix of high all-in-yields and falling duration is “creating a powerful forward total return profile” that offers attractive compensation for the risk of spread or rate shocks over the medium term.
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