European High Yield: Cautious and Selective Despite Wider Spreads

Why an active approach, including strong fundamental analysis remains critical for high yield investors

With European high yield (HY) spreads nearing two-year highs, investors are taking notice. In contrast to comparatively stable levels in the U.S., European HY spreads have nearly doubled since October 2017 (see chart). As a result, and for the first time in over five years, high yield spreads are wider in Europe than in the U.S., despite their higher average credit rating (BB- in Europe versus B+ in the U.S. Source: BAML/ICE).

Although valuations are starting to look more interesting at these spread levels, the broader market remains less compelling. Beneath the surface, dispersion among issuers is growing, fundamentals are deteriorating, and the importance of credit selection is increasing. An active approach, including strong fundamental analysis to identify select opportunities remains critical.  

European High Yield Outlook: Cautious and Selective Despite Wider Spreads

Under the surface: Technical and fundamental challenges amid growing dispersion

The initial catalyst for high yield spread widening in October 2017 was index composition changes: Several issuers entered the ICE BofAML European Currency HY Constrained Index at substantially wider spreads than those leaving. This was followed swiftly by poor earnings results from several larger, primarily B rated benchmark issuers, and thereafter by a number of name-specific credit concerns. Political uncertainty in Italy added further momentum to the sell-off, particularly as approximately 15% of the European HY universe is composed of Italian issuers. Outflows from European HY mutual funds this year estimated at -€5.7 billion through 30 September, together with net positive supply of €6.4 billion over the same timeframe also contributed to the weak tone (Source: JP Morgan).

Added to all this, the general slowdown in European growth could lead to higher leverage ratios should earnings weaken and debt reduction efforts stall. While the aggregate level of leverage is not (yet) a cause for alarm, the markets are likely to increasingly price in the potential for future re-leveraging, and issuers that are outliers may face challenging trading conditions ahead. Equity weakness, if it persists, would only exacerbate this trend, with declining valuation multiples placing incremental pressure on company balance sheets.

Amid this backdrop, dispersion among individual issuers is increasing. According to Bank of America Merrill Lynch, dispersion (as measured by the proportion of European HY bonds dropping more than 10 points in a month) is at three-year highs and climbing, indicating declining investor support for weaker credits as liquidity is withdrawn.

Investment implications

In light of all these factors and  the potentially negative side-effects of the European Central Bank (ECB) ending its (investment grade) corporate bond purchases this year and likely raising rates in 2019, we believe it is too early to turn constructive on European HY.

However, as active managers we see three big opportunities in this environment of increasing volatility. First, avoiding the weakest credits can and likely will be an increasing source of alpha. Second, opportunities can be found by identifying credits whose prices have fallen below what their fundamentals indicate, or those that have reached an inflection point and whose fundamentals are improving. Third, the primary market will provide potential opportunities to selectively add exposure in favoured issuers offering attractive new-issue premiums.

Overall, we believe that at this late stage of the credit cycle, and in light of increasing dispersion, active management will be key to finding these opportunities and generating attractive risk-adjusted returns in the European high yield sector.

Enjoyed this article? Subscribe to receive updates to the PIMCO Blog.

The Author

David Forgash

Head of Leveraged Loan Portfolio Management

Matthew Livas

Credit Product Strategist


Related Funds


PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

PIMCO Europe Ltd - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

PIMCO Deutschland GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Italy branch is additionally regulated by the CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are  authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Swedish Branch is additionally supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act. he services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-, Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.

XDismiss Next Article