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The last decade has seen investors in European high yield (EHY) experience plunging interest rates, and borrowers in the primary market squeeze the coupons on their bonds to ever tighter levels. As a result, in the 10 years to 2022 the average market-weighted coupon in the ICE BofA Euro HY Constrained Index fell from 7 per cent to a low of 3.5 per cent.
This process was not universally bad for HY investors, of course, as lighter interest burdens aided companies’ finances and implicitly reduced the risk of credit crunches and defaults. But, as this week’s Chart Room shows, the market’s five-year returns - made up of both the bond coupon (income component) and spread (price component) - tumbled from an average of 6.4 per cent between 2013 and 2017 to a meagre 0.5 per cent in the period 2018 to 2022.
The income component, as the chart shows, always remains positive and over time tends to absorb any fluctuations in spread/price movements - it is effectively what attracts investors to this asset class. Moreover, in recent months, EHY coupons have turned upwards for the first time in more than 10 years and will rise further. Bonds are indeed back.
The restoration of higher income, however, also comes with higher risk. After a decade in which HY issuers became used to refinancing their maturing notes at ever-lower coupon rates, they’re now facing a world in which they will need to pay higher coupons each time they access the primary market. For a short duration, short tenor asset class such as high yield, where issuers return to refinance their debt on average every three to five years, the impact of these rising coupons could be tricky.
The majority of the EHY universe is made up of solid BB-rated issuers (69 per cent as at 30th June 2023) which, at one notch below investment grade, are for the most part able to swallow an increase in coupons. Single-B and CCC rated firms, especially privately-owned or highly-levered ones, will be strongly tested in the next round of refinancing, particularly if their business plan has relied on easy access to cheap financing to fuel future growth.
Some treasurers have chosen to sit out the rise in coupons so far, believing that rates will come back down, especially if their debt is maturing around 2025-2026 (as a large part of bonds in the European HY index are). The risk of course is that rates stay elevated and those companies will face even higher costs to refinance a few months down the line. We are actively encouraging all our investee companies to tackle their maturity risk sooner rather than later.
Natural selection will of course play out - the stronger corporates will survive, while those that fail will be part of the price for undoing one of the many distortions of the quantitative easing era. This environment will give rise to opportunities for diligent active managers to showcase their credit selection skills, but, from an investor’s point of view, one of the key attractive features of this asset class is back, as higher future coupons bode well for higher future returns.