The chart
The portion of the European high-yield debt market trading at distressed levels has risen (the distress ratio has increased), yet index valuations are historically high (credit spreads are very tight). There’s a dislocation between market valuations and fundamentals.
Source: ICE BofA, Bloomberg, Ninety One, August 2024.
The context
This isn’t the first time we’ve pointed out how expensive the high-yield market is in terms of tight credit spreads (see misleading mean and fat tails and phantoms). Excluding crisis periods, the proportion of bonds in the European high-yield market that are trading with a spread in excess of 1000bps (i.e., distressed) is relatively high, as shown in the chart. Crucially, credit spreads are tight given the current level of market distress seen today.
Equally stark is what is driving this higher level of market stress. Typically, a sector-specific theme has caused the ratio to peak (for example, stress in cyclical or commodity orientated sectors). Today, stress appears widespread, with the weakest and most leveraged companies in a variety of sectors – including typically defensive areas such as healthcare and telecoms - being punished in the form of outsized credit spreads. The abrupt change in interest rate regime of the past few years is to blame for this, driving fear among investors around the creditworthiness of over-stretched borrowers even if they operate in typically stable sectors.
The conclusion
Investors in European high-yield debt are earning a low credit spread, especially in the context of the relatively high amount of distress in the market. In fact, market distortions mean high-yield valuations are even higher than they appear, for similar reasons to those outlined here.
Selectivity remains key in this environment, and the high level of dispersion seen in credit markets today means investors can find better value away from many high-yield assets. We see a better risk-reward proposition in areas such as structured credit and select parts of bank capital and investment-grade markets, which also offer an attractive income profile and more favourable downside characteristics.
