Talking Heads – It is ‘more of the same’ for European high-yield bonds

This is an audio transcript of the Talking Heads podcast episode: It’s ‘more of the same’ for European high-yield bonds 

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing European high-yield debt. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Olivier Monnoyeur, Global Head of High Yield. Welcome, Olivier, and thanks for joining me.  

Olivier Monnoyeur: Thanks for having me today.  

DM: One of the pleasant surprises over the last year has been the performance of high-yield debt, perhaps to some degree, a mirror image of the good performance we’ve had in equities, and not so concentrated in just one sector [tech], but more broad-based. There seems to be a lot of good news [falling inflation, a soft landing in the US] already priced in high-yield, particularly if we look at the spreads, which are low. That would suggest there’s not a lot of cushion if something bad happens. Could you give us an update on what’s been happening in European high-yield so far in 2024? 

OM: A bit more of the same, I would say, in terms of spread direction, at the end of last year. So, the market is seeing inflows. Investors have cash to deploy and there is not enough bond supply. Spreads have been tightening with the economy not seeing many signs of stress. The soft-landing argument appears generally valid, even in Europe.  

The one difference at the end of last year was that central banks pulled back on [interest] rate expectations for 2024, so [spreads] started to widen after the euphoria of November and December. That has created a partial correlation between rates which have widened and spreads that are continuing to tighten. We will have to see how long that lasts.  

We think the big picture for 2024 is that central banks will cut rates, which makes the bond market an attractive place to invest again. It will also ease the burden on the most indebted companies, which is a positive for high-yield and that could support the asset class this year.  

The other thing we are seeing is spread compression between riskier credit and higher quality credit. This is the consequence of valuations. The better rated part of our investment universe does not seem to offer much more upside here. It’s really just about the carry on this one [argument] – that rates can continue to rally. At the lower rated end of our market, things are starting to open up for B rated. In some cases, for CCC rated issuers, the mergers and acquisitions market is waking up.  

Companies are now turning to see what they can sell at good prices, so they can take care of short-dated debt, improve their balance sheet and cash flow metrics. On that basis, default rates will remain fairly low this year and we retain a constructive outlook for our asset class in 2024.  

DM: You look both at bonds that have already been issued and are being traded, and new issuance by companies looking to raise debt via high-yield bonds. How have things changed for companies wanting to issue high-yield bonds recently compared to what you saw last year? 

OM: Surprisingly, the primary market for new issuance has not been as busy as expected in terms of volume and [it has] certainly not [been] sufficient to satisfy demand. It’s been mostly about refinancing, replacing [issues] mostly for the better rated part of the market, say BB and BB+.  

There is an expectation that activity will pick up this year and clear the way not just for better quality names, but also for higher leverage situations. We work on trying to position for 2026 bond maturities – so, bonds with a two-year horizon that we see coming with early refinancing and where the bonds trade at a significant discount. Those 2026 bonds are interesting because on a yield-to-final maturity [basis], they may not look so attractive, but in terms of early refinancing, the return starts to be quite good given the discount to par.  

Some of these new debt transactions are happening now, but not just in the bond market. We are also seeing some bonds being refinanced with transactions in the leverage loan market, which is improving the supply/demand balance in high-yield bonds. I would say the market is lively and ready to receive new issuance and investor appetite is certainly much improved versus six months ago.  

Some issuers are being cheeky and offering to tender bonds below par – for example, at 98%  when the expectation from bondholders is that you should get par because that is where those bonds are callable. It’s like you lend me £100, and I come back six months later and repay you only £99, saying ‘interest rates are higher, so here’s less money’. You wouldn’t like that, would you? But for the most part, we expect issuers to behave well and treat bondholders fairly.  

The other thing we’re seeing at the moment is where a company in a difficult sector or with a chequered history is exchanging its short-dated low coupon bonds for longer-term maturity bonds, with a much-improved coupon. Generally speaking, these transactions are done on attractive terms and have been well received by the market. We expect to see more of these in the telecommunications, real estate and chemicals sectors.  

DM: You see the environment as supportive, with interest rates set to fall this year, and issuance being not quite as much as you expected at the beginning of the year. With all that in mind, what are you and your team doing? 

OM: We are struggling to find much value in crossover names, especially from sectors we view as more challenged, like the automotive sector. So, we have been less active and [less] excited by the levels in the primary markets.  

On the highly-rated issuers so far this year – even in the secondary or existing bond market – it makes less sense to chase those BB rated companies, but we still like hybrid bonds. These would include subordinated bonds with an equity component coming from non-financial issuers, as they give us some premium versus BB rated companies. We don’t mind the subordination that comes with these bonds.  

It’s a similar picture for AT1 instruments – the most subordinated bank bonds just above equity in the capital [structure] of a bank. Here, we think banks are generally well capitalised and AT1 instruments offer a decent premium for the risk. So, we expect to remain active both in hybrid bonds and AT1 instruments.  

Apart from that, there’s been a lot of reassessing of the situation with B rated issuers where we have identified a catalyst like the sale of an asset, or a turnaround where we expect an improvement in operating performance, or simply [an area] we have not invested in before, but where the cash flow performance has been better than expected.  

I would caution though that there are still situations that look challenging and thus not an option. This is no time to be complacent, but generally speaking, we expect default rates to remain low and we are deploying some capital in the real estate sector that could benefit from the expected rate cuts. We’re still cautious there as we expect defaults and downgrades.  

There are cases that look quite compelling on a valuation basis as they are highly discounted, and we can see a path to push up maturities and preserve cash flows.  

DM: Olivier, thank you very much for joining me. 

OM: Thank you for having me today.