Euro HY: Risk Recalibration?

CreditSights Staff

  • As investors adjust macroeconomic expectations for a potential recession, credit selection and fundamentals will become increasingly important. We’ve polled our analysts for HY picks to help these investors find opportunities that offer stability, or upside potential, in a more challenged environment.
  • Investors looking to insulate portfolios from near term macroeconomic risks should consider defensive sectors with less cyclicality: TMT, Services, Consumer Staples and Luxury Goods. In these sectors, we are more inclined to move down in ratings/credit quality or down the capital structure to take on subordination risk where the spread pick-up appears attractive relative to historical levels. HY credits we like here include T-Mobile Netherlands (subs), Altice France (Holdco), Techem (subs), Almaviva, Cirsa and Lottomatica.
  • Within cyclical sectors, we prefer an up in quality/rating strategy or recommend that investors focus on credits with strong balance sheets, healthy cash balances and/or limited near-term liquidity needs. As duration headwinds drove the first round of volatility this year, many of these stronger companies have been sufficiently beaten up and now trade well below par. HY credits we like in this category include Cemex, Hapag-Lloyd, eDreams, Loxam and Dufry.

Upward pressure on inflation and rates has driven a painful market sell-off YTD 2022, with investors first shedding duration and, more recently, pivoting to focus on credit risk as the prospect of a recession looms in the distance. The ECB’s recent 50 bp rate hike was a key step toward more restrictive financial conditions, but, based on comments from President Lagarde, is likely to be followed with further policy tightening. Energy prices in Europe remain acutely exposed to the Russia/Ukraine war, keeping inflation elevated and exerting downward pressure on consumer spending, and Italy has recently added political uncertainty to the fray with the resignation of Prime Minister Mario Draghi and snap elections in the fall. Taken together, these factors bring macroeconomic and credit risk to the fore.

Despite a strong rally in July, Euro HY spreads are still 252 bp wider YTD, while yields are 390 bp higher. With this move, market participants are beginning to wonder whether rate risk is more fully priced into valuations. At the same time, recession concerns are taking precedence as the primary downside driver, calling into question the outlook for downgrades, defaults and lower-rated market valuations. Given the shifting focus on credit risk and away from duration, the HY opportunity set and broader asset allocation strategy are also changing. While some investors with a more cautious view on fundamentals may be looking to move up in quality, others are on the hunt for HY credits that have become more attractive buying opportunities.

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