The overall outlook for the European high yield market remains stable – benefiting from reasonable macro fundamentals, low volatility, hawkish sentiment being seen as an end-of-year or 2018 concern, and political uncertainty being ignored to an extent.
When assessing the prospects for European high yield for the remainder of the year, it is important to look at the three factors underpinning the asset class: technicals, fundamentals and valuations.
Robust technicals: all eyes on the new issue pipleine
The technical picture is robust: the default rate is low and flows into the asset class have been positive year-to-date, while on the supply side there has been a pickup in new bond issuance. According to JPMorgan, over €48bn was issued in the first half of 2017, which is more than 80% of last year’s new issuance total.
It is possible we could see more acquisition-related bond deals brought to the market this year given the recent uptick of leveraged buyouts in Europe, such as Cinven and Bain’s Capital buyout of German drugmaker Stada. As always, the timing of new deals will be pivotal, particularly given the backdrop of geopolitical tensions, a possible slowdown in China and the looming prospect of an end to the long period of ultra-accommodative monetary policy – all of which are potential triggers for volatility in the coming weeks and months.
Solid fundamentals: the ECB remains in focus
Fundamentals underpinning the asset class are solid, with average corporate leverage declining and interest coverage ratios increasing. Corporate earnings are also on an improving trend, which is encouraging. The European Central Bank’s (ECB) accommodative stance is also supportive.
Still, we recognise that, given improvements in the eurozone economy, the central bank may turn more hawkish later this year and announce a further tapering of its bond-buying program to start next year. While this has the potential to generate some volatility in the asset class, we believe the ECB’s path to normalisation is likely to be slow, ensuring a key support remains in place for the foreseeable future.
Tight valuations: spreads near post-financial crisis lows
European high yield has enjoyed a strong run: yields have compressed sharply and spreads are close to post financial crisis lows. This has led many investors to question how much longer it can last. While we understand these concerns and acknowledge the possibility of spreads widening in the asset class at some point, identifying the catalyst for a possible change or reversal in conditions – and predicting when it will happen – will be difficult.
Taking all these factors into account, it is possible spreads will continue to tighten as the fundamental and technical factors underpinning the asset class remain so supportive. However, valuations call for a cautious approach. As usual, credit-intensive, bottom-up research will be imperative in order to find potential opportunities.
Mike Della Vedova, portfolio manager of the T. Rowe Price European High Yield Bond Fund