Chart of the Week
In just one year, yield to maturity (YTM) levels for European high yield rose from 3% to over 8% before retracing to 7.3% at the start of this month. Behind the upward move is a rise in the risk-free rate (currently around 2%) and higher spread levels (around 5%). While high yield has performed negatively for the past year, expected yields are now significantly more generous.
OUR ANALYSIS
The increase in high yield spread levels means a higher probability of default in the segment. Moody’s suggests that in the 12 months up to the end of next October, the default rate could reach 4%. This compares with 2.5% over the past 12 months and 1.3% in 2021. While investors have already priced in higher default risk, deteriorating economic conditions in the next 12 months could result in a higher-than-expected default rate of up to 5–6% including partial defaults.
If this scenario were to materialise, then we would expect yields and/or spreads to increase accordingly. However, debt holders would be cushioned from the negative effects by generous yields. As things stand, only a cumulative rise in yields and spreads of around 240 bps (2.4%) would offset the 12 month performance currently being posted by high yield. We believe this to be an unlikely scenario and aside from any short-lived peaks, risk premia are not set to remain at such elevated levels.
Against this backdrop, the high yield segment seems to be back in favour with investors. Following record outflows of €12.6 billion – 15% of AuM – from European high yield funds between January and October 2022, the tide has turned in recent weeks with inflows of €209 million from 17–23 November and €48 million from 24–30 November*.
* Source: J.P. Morgan, European Credit Fund Flows.
The opinion expressed above is dated December 9, 2022 and is subject to change.
See also: https://latribune.lazardfreresgestion.fr/en/eurozone-inflation-has-become-broad-based/
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