European High Yield: High Yield, High Expectations

While the valuations of a number of asset classes now look stretched, that is not the case for European High Yield, which screens among the most attractive segments in global fixed income. Given that EUR HY remains supported by robust fundamentals, and that the macro environment is turning more favorable — including expected central bank rate cuts — we believe that now may be the time to consider increasing exposure to EUR HY. We at MFS^_® express our EUR HY views mainly through our global HY portfolio, our global multi-sector mandate and our EUR credit strategy.

EUR HY yields are attractive by historical standards. At about 6.56%, index-level EUR HY yields stand well above their 10-year rolling average of 4.53% (Exhibit 1). This is a major consideration as the current yield directly impacts future return expectations. 

Entry points matter in fixed income, including EUR HY. Given the attractive level of current yields, the outlook for expected returns is robust, in our view. This is because there has historically been a strong relationship between starting yields, like today’s, and relatively attractive subsequent returns. For instance, at a starting yield of 6.56% for EUR HY, the median return for the subsequent five years — using a 30-basis-point range around the starting yield — stands at 7.9%, with a return range of 5.49% to 9.44% (Exhibit 2). In addition, the prospects for fixed income expected returns have been strengthened by recent signals of forthcoming rate cuts from the major central banks, including the European Central Bank. Analyzing the heat map for EUR HY (Exhibit 3), it’s clear that the likelihood of higher returns has gone up, compared with a few years ago, reflecting the higher starting yield. In addition, the outlook for higher returns is also supported by the strong possibility of rate cuts in the pipeline, based on recent ECB policy signals. Specifically, based on an entry yield of 6.56% and assuming no spread move over the next year combined with a drop in rates of 60 bps, a hypothetical return of 8.19% in one year could be realizable, based on the impact of a 60bp rate move to be multiplied by the index duration (60 x 2.71 = 162.6, which when added to 6.56% leads to 8.19%). By way of historical comparison, the 20-year annualized return for the asset class stands at 6.6%.

Meanwhile, it is also worth noting that under an extreme scenario — such as a combined rise of at least 270 bps for spreads and rates — would lead EUR HY to produce a negative return over the next year.

space

EUR HY spreads are still in attractive territory. This is particularly true when looking at break-even spreads (Exhibit 4). In keeping with other global fixed income asset classes, EUR HY spreads have tightened substantially over the past few weeks. But in contrast to its peers, we believe the spread valuation picture remains broadly attractive. 

EUR HY remains supported by robust fundamentals. Overall, we are not concerned about a sharp rise in default rates or the so-called maturity wall. Refinancing risk remains limited in view of the prospects for rate cuts and a peak in maturities that may only materialize in 2026 (Exhibit 5). Fundamentally, the asset class has strengthened over the past few quarters, based on our Fundamental Indicator (Exhibit 6). The main source of strength arises from the free cash flow to debt ratio, along with the net leverage backdrop. 

The macro environment is turning more supportive of EUR assets. On the growth front, we are detecting some green shoots of improvement in macro conditions in the eurozone, though the baseline scenario remains one of near stagnation. However, the good news is that severe recession risks seem to be fading. Our Business Cycle Indicator for Europe, which aggregates several relevant indicators, points to a noticeable uptick from a couple of months ago (Exhibit 7). For instance, the well-followed ZEW indicator for eurozone growth expectations just reached its highest level in a year.

In addition, the ECB is likely to kick off an easing cycle soon, perhaps as early as Q2 this year. In our view, this is likely to boost the appetite for EUR assets which should benefit EUR HY.

space

EUR HY is attractive against US HY on a relative value basis. This mainly reflects the fact that US HY valuation looks particularly stretched. Specifically, the differential between the EUR HY and the US HY  break-even spreads currently stand at 35 bps, well above the 1-sigma threshold from the long-term average (Exhibit 8). 

Likewise, EUR HY also looks particularly attractive when looking at hedged yields. A US-based investor seeking exposure to EUR HY on an FX-hedged basis could realize a yield of 8.04%, higher than what the investor would experience when buying US HY — despite the shorter duration of the EUR index (Exhibit 9). 

space

EUR HY’s long-term performance compares well relative to that of US HY. Looking at the return history, EUR HY (in USD terms) has delivered stronger returns than US HY over the 3-year, 5-year, 10-year and 20-year horizons. In addition, given that the return volatility of EUR HY has been broadly similar to its US peer, it means volatility-adjusted returns have been consistently higher (Exhibit 10).

Exhibit 10: Historical Returns of EUR HY (USD terms) and US HY

Source: Bloomberg. EUR HY (USD hedged) = ICE BofA European Currency High Yield Index, HP00 index, total return, hedged to USD. US HY = Bloomberg US High Yield Total Return index. Volatility = annualized volatility of monthly returns. Vol.-Adj. returns = return /volatility. Based on monthly data up to Jan 2024. Past performance is no guarantee of future results. It is not possible to invest in an index.

EUR HY’s long-term performance also compares well to that of European equities, although it has lagged equity performance substantially over shorter time horizons. Looking at the past 20 years, EUR HY has produced broadly similar returns relative to the Euro equity index, but with less volatility (Exhibit 11).

Exhibit 11: Historical Returns of EUR HY and EUR Equities

Source: Bloomberg. EUR HY = ICE BofA European Currency High Yield Index, HP00 index, total return. EUR equities = Euro Stoxx 600 Gross Return (SXXGR index). Volatility = annualized volatility of monthly returns. Vol.-Adj. returns = return/volatility. Monthly data up to Feb 2024 (as of 16 Feb). Past performance is no guarantee of future results. It is not possible to invest in an index.

The technical backdrop for EUR HY is supportive. It is worth noting that the size of the market has shrunk since Covid, due to restricted supply (Exhibit 12). We would argue that this scarcity is acting as a positive technical driver. In addition, the EUR HY market offers significant country diversification, which helps manage the individual country macro risk exposure, as illustrated by Exhibit 13.

space

WORST CALENDAR RETURN: 2022

Overall, we believe that EUR HY is an asset class that deserves to be on investors’ radar given its attractive valuation characteristics, fundamental strength, favorable technicals and long-term performance record relative to comparable asset classes.

Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates.

Source: Bloomberg Index Services Limited. BLOOMBERG^_® is a trademark and service mark of Bloomberg Finance L.P. and its affi liates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Bloomberg neither approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The views expressed herein are those of the MFS Investment Solutions Group within the MFS distribution unit and may differ from those of MFS portfolio managers and research analysts. These views are subject to change at any time and should not be construed as the Advisor’s investment advice, as securities recommendations, or as an indication of trading intent on behalf of MFS.