Over the last two years, the euro high-yield segment has performed well, with relatively low volatility. It has shown resilience to both external shocks and negative idiosyncratic events within the high-yield universe. We think this demonstrates that the segment is now more mature and of better intrinsic quality than a few years back.
After two years of strong performance – 12.78% in 2023 and 8.92 in 2024* – we anticipate the European high-yield market will once again prove attractive to investors seeking yield in 2025. We see good prospects for another year of attractive returns in an environment where the glass is more than half full, rather than half empty.
Valuations and returns
Spreads tightened significantly in 2024, by around 85 basis points*. As a result, valuations may appear less compelling, but we see current levels as sustainable. In the past, we have seen spreads remain at these levels for meaningful periods.
Today, yield (rather than spread) is the main driver for credit markets. The rise in interest rates means yields are now at levels that can accommodate any spread volatility and protect carry. In our view, the index’s* current yield of 5.038 (for the Merrill Lynch, BB-B excluding financials benchmark, as of 31/12/2024) is still attractive, particularly if, as expected, interest rates in Europe remain on a downward trend.
Volatility also favours the high-yield market. As short duration instruments, Euro high-yield bonds have relatively moderate volatility, certainly compared to equities or even investment-grade credit. This explains the segment’s attractive Sharpe ratio. While there is limited scope for further significant spread tightening in 2025, we expect carry to drive performance.
We are constructive on prospects for Euro high yield in 2025. We took advantage of the rise in bond yields in early January to increase risk in Additional Tier 1 bonds, hybrid bonds, mid-duration high quality BB rated credits and some issues affected by idiosyncratic aspects among the single B names in our universe. Our credit analysis also found solid risk/return profiles in the healthcare, technology and non-cyclical consumer sectors of the universe.
As a result of this repositioning, we are now running a higher yielding strategy with a running yield of just over 6%. This compares to 5.03% for our benchmark*.
Our approach to Euro high yield is a high conviction strategy, with our largest exposure being to the real estate sector which we expect to show further normalisation in 2025 as asset disposals accelerate, helping to de-risk balance sheets.
Last year, we initiated a large overweight position in the real estate sector at a time when valuations of bonds in the sector were troughing and fundamentals were starting to recover from the crisis. This proved to be a highly differentiating position as high-yield bonds in this sector* returned 36.80% in 2024 compared to a return of 8.92% (for the Merrill Lynch Euro HY BB-B excluding financials, index).
A better outlook amid all the doom and gloom
We have recently reduced our underweight to cyclical sectors. In our view, the pessimism about the situation and outlook for the European economy has reached an extreme. Europe seems to have been written off by some investors who may now be underexposed to the region amid the general euphoria about US financial assets. As a result, we see a tipping point as having been reached in terms of sentiment, with scope for outperformance from neglected European assets.
It seems to us that European growth is stabilising, albeit at a low level. Over the course of 2025 we see events that have the potential to lift the clouds over the continent and improve the outlook. For example, this year may see an end to the Ukraine war.
The European Commission has just unveiled the EU compass for competitiveness. This compass translates the measures from the Draghi report into the commission’s policy roadmap for the next years, with specific initiatives to be released along the way. The plan is potentially a promising step towards addressing the EU’s deep-seated structural issues. Besides promising simplification measures, EC President van der Leyen has spoken about supporting the automotive and energy intensive industries.
In Germany, the federal elections on 23 February will likely lead to a new coalition, led by the centre-right business friendly CDU/CSU. With Germany at risk of a third consecutive year of economic contraction, this new government will have every incentive to do all it can to boost growth.
Euro high-yield companies’ fundamentals are solid
With European economic growth currently sluggish, corporate investments and mergers and acquisitions (M&A) activities remain subdued. Companies in the high-yield universe are prioritising debt reduction and have access to a very healthy primary market. We suspect that the technical factors that supported the Euro high-yield segment in 2024 – namely, inflows into mutual funds and demand for collateral for Collateralized Loan Obligations – are here to stay in 2025.
Inflation is on a downward path across the eurozone. Lending conditions are expected to improve with the European Central Bank on course to cut its deposit rate to at least 2% by this summer.
Our analysis shows the fundamental characteristics of companies in the Euro high-yield segment as being relatively solid. Corporate results for the region continue to demonstrate the resilience of business models. Profit margins are stable, costs are well under control and there is sustained cash generation.
We see few candidates for restructuring. Default rates have declined, and we expect them to remain contained at around 3%, possibly even lower. Overall, high-yield issuers are maintaining solid and resilient financial ratios. We can envisage further improvements in 2025.
*Source: BNP Paribas Asset Management, data quoted is for the Merrill Lynch Euro High Yield index BB-B excluding Financials, as 31/12/2024.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation, and conservation on behalf of funds invested in emerging markets may carry greater risk.
