Leveraged Finance
EuropeanHighYieldEntersANewDefaultParadigm
5 mins
In late 2020, we outlined five factors that were set to support the European high yield market going forward—one of which was an evolving, low-default environment. While European high yield bonds have rallied strongly since the depths of the COVID crisis, our expectation for additional spread tightening over the medium to long term is underpinned by our proprietary default analysis, which continues to reflect several factors allowing issuers to reduce their cost of capital and extend their maturities as they enter what will likely become a new paradigm of historically low defaults.
During the depths of the COVID crisis in mid-2020, our bottom-up default analysis concluded that defaults would remain well below 3% over the next 24 months, far less than the consensus views at the time that generally focused on a top-down approach and largely failed to incorporate how monetary and fiscal stimulus would support individual corporations. Since then, the economic recovery in Europe has strengthened, corporate earnings have surprised to the upside, and credit fundamentals have continued to improve. In order to assess how this rapidly changing backdrop might affect the corporate default rate one year after our prior analysis, our credit analysts recently repeated the exercise.
Still Below Consensus
Although the methodology of the analysis is straight forward—based on the macro and corporate environment, the analysts indicate which credits in their coverage universe might default over the next 12 months—the coverage is extensive as it covers about 95% of the benchmark index. The most recent results indicate a default rate of 1.0% over the next 12 months, which remains below consensus estimates and would be the lowest rate in more than a decade.1
For example, the trailing 12-month default rate peaked at 5.06% in November 2020 and ended June 2021 at 4.00%, according to Moody’s Investors Service. Moody’s expects the default rate to decline to 2.16% over the next 12 months, which is more than double the rate of our analysis (Figure 1).
FIGURE 1
Our Default Estimates Point to the Lowest Rate in More Than a Decade
Moody’s Investors Service, trailing 12-month default rate as of June 2021.
High Support Levels
The highly coordinated monetary and fiscal policies since the outset of the pandemic have included negative policy interest rates, quantitative easing, targeted loans, tax breaks, compensation programmes, and furloughs. For example, on the fiscal side, Germany set aside more than €10 billion to compensate affected businesses with more than 50 employees up to 70% of their lost revenue in comparison to November 2019.
Moreover, this support boosted liquidity in the capital markets, which allowed companies to recapitalize, but not necessarily by levering up. Companies in some of the hardest hit sectors, such as gaming, travel, and leisure, initially raised equity capital once the markets opened up in mid-2020. With the support of equity sponsors and lenders, companies enhanced liquidity, refinanced debt at a lower interest rate, and extended their maturity profiles. As a result, the average coupon in the European high yield market dropped nearly 50 bps from the end of 2019 to its recent level of about 3.50% as of late July, and maturities were extended in each year out to 2026 (Figure 2).
FIGURE 2
High Yield Issuers Extending Maturities
Morgan Stanley, LCDComps.
Distressed funds also raised a considerable amount of capital in 2020, which can be deployed to support companies in avoiding default and/or to purchase assets following default. The latter enhances recoveries for creditors, thereby reducing the cost of default. Our default analysis generated a recovery estimate of 47.5% over the next 12 months, which is on the high side of historical averages in the mid to high 30% range.
Corporate performance has also improved as economies emerge from lockdowns. EBITDA growth has rebounded from a 15% contraction and total debt has stopped growing—underscoring the breadth of corporations’ balance sheet repair as about 50% of 2021’s first half issuance of about €64 billion (about twice the volume from the same period a year earlier) consisted of refinancing and recapitalization transactions. And the recovery in free-cash flow growth has lifted the free-cash flow-to-debt ratio to the highest level in more than a decade (Figure 3).
FIGURE 3
EBITDA Growth Stabilizes as Free-Cash Flow-to-Debt Ratio Reaches Highest Level in More Than 10 Years
Morgan Stanley Research, Bloomberg company data.
In aggregate, the combination of factors has resulted in very few distressed credits. At the end of June, only eight bonds traded below a cash price of 80, comprising only 0.40% of the European high yield market. In spread terms, only 20 bonds, or 1.1% of the market, traded with spreads in excess of 1,000 bps.
While our short-term optimism is tempered by the tail risk of COVID mutation that sets back vaccination efforts or that central banks pre-emptively over tighten policy to address inflation concerns (amongst other risks), we believe the European high yield market will remain resilient amidst the combination of factors providing the sector with consistent fundamental tailwinds.
Full valuations are another short-term consideration, yet over the longer term, active credit selection can continue identifying pockets of value that emerge, particularly in segments of the market where the new, low-default paradigm has yet to be priced in.
1 Based on a 12-month trailing basis.
