Rising interest rates and continuing tension surrounding the Ukraine conflict have brought the issuance of high-yield corporate bonds in Europe to a virtual standstill. “The size and speed of the current interest rate increase is causing companies to stop going public and the market to virtually dry up,” said one specialist.
The European high-yield market is facing its lowest quarterly issuance in six years. Corporate bond issuance in the primary market has been hit by the war between Russia and Ukraine, which increases the risks of inflation, rising interest rates and possible stagflation. On the secondary market - where issuers trade - relatively low spreads show the effect of anticipated interest rate hikes.
Only 40 deals in 2022
According to data of the Association for Financial Markets in Europe (AFME), only 40 high-yield bond deals have been concluded in Europe so far this year, with a total volume of 17.5 billion euro. In 2021, no less than 200 billion worth of deals were closed in Europe.
Moreover, the deals done are smaller in size than before. According to a report by the S&P Global research agency, the average issuance by debutant borrowers was around 475 million euro until mid-March. The average value of issuance by seasoned borrowers, at almost EUR 325 million, was much smaller than a year ago. At that time, the average value of the deals they had done amounted to EUR 532 million.
According to Hendrik Tuch, head of fixed income at Aegon Asset Management, the low supply of European high yield corporate bonds in the past three months mainly shows that companies have to get used to the higher interest they will have to pay before they place a new bond.
“As with other segments of the bond market, investors expect higher yields and higher spreads on new bonds. This clearly shows how a tighter monetary policy by central banks will affect all markets,” said Tuch.
‘HY spread shows zero chance of recession’
The European high-yield spread - the difference between the yield of low- and high-quality bonds with comparable maturities - widened during the year, reflecting higher funding costs. But, still, spreads are considered too narrow.
According to Jeroen Blokland, founder of research firm TrueInsights and former head of Robeco’s multi-asset team, the spread in the European high-yield market shows a zero probability of a recession.
He compared the current spreads with those of previous periods around recessions. “Zero per cent is obviously unrealistically low. We have spreads that are even too low for a large, possible increase in bankruptcies.”
Blokland: “The size and speed of the current interest rate increase is causing companies to stop going public and the market to virtually dry up. That does not happen in a positive environment. It may be that if new corporate bonds are issued that spreads will widen to healthy levels, but as long as those same spreads indicate a probability of a recession not exceeding zero per cent, I am not very positive about high yield.”
‘Subordinated bonds have higher beta’
Technically, the longer the primary market - for corporate bond issuance - remains stagnant this year, the greater the risk of companies defaulting as capital is cut off. However, Lucy Isles, co-manager of the European high yield fund at Baillie Gifford, argues that refinancing needs are actually limited.
“Although fewer bonds are being issued, the recent sell-off driven by systemic risk factors in the secondary market has created opportunities to lend to companies at attractive valuations. These subordinated bonds have a higher beta than the market and provide an excellent investment opportunity for portfolios,” Isles said.
Baillie Gifford recently added Rakuten’s European-issued hybrid bonds to the portfolio. Rakuten is investing heavily in a new mobile network in Japan and this has put bond investors off, according to Isles. “I think the concerns are exaggerated, given Rakuten’s strong balance sheet and the many levers it has to keep its credit rating in order. Rakuten has an extremely loyal customer base, making it well positioned for cross-selling its new services.”
Opportunities and Risks
While debt issuance has been tempered by current market conditions, the ongoing consolidation is being boosted by cheaper equity valuations, says Isles. “Equally important, she says, is the build-up of capital to fund the transition of European businesses to a sustainable economy. In many ways, this is arguably reinforced by the conflict in Ukraine,” said Isles.
“Obviously, an escalation of the war in Ukraine poses a risk to the European high-yield market and to the achievement of ESG targets. Also, China’s ‘zero tolerance’ strategy on Covid-19 may fail, prolonging supply chain problems and inflation. Finally, there is a risk that central bankers could make a mess of things with tightening policies.”
Isles believes that the possibility of a growth shock reinforces the importance of identifying undervalued resilience at the corporate level or unexpected risks in portfolio construction.
This article originally appeared on InvestmentOfficer.nl.