Conditions in the European high-yield debt market are currently favourable for investors argues Olivier Monnoyeur, Head of High-Yield Debt. Among potential clouds on the horizon are weakening economic fundamentals and the significant volume of debt to be refinanced in 2025 and 2026. Now, Olivier argues, is the time to deploy capital in high quality assets, based on rigorous balance sheet analysis and security selection.
Listen to this Talking Heads podcast with Olivier Monnoyeur, Head of High-Yield Debt and Chief Market Strategist Daniel Morris as they discuss positioning in European high-yield debt to meet the challenges ahead.
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Read the transcript
This is an edited transcript of the audio recording of this Talking heads podcast
Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing high yield debt. I’m Daniel Morris, Chief Market Strategist, and I’m joined by Olivier Monnoyeur, Head of High Yield. Welcome, Olivier, and thanks for joining me.
Olivier Monnoyeur: Thanks for having me today.
DM: Over the last year, we’ve had one of the fastest and steepest ever tightening cycles. Growth has slowed, but perhaps not by as much as we would have expected. At the same time, inflation is slowing, but equally, not by as much as the central banks would like. The US markets are pricing in cuts from the US Federal Reserve (Fed) soon, and there are still expectations of recession, although we don’t know when or how deep that will be. But the environment of rising rates and slowing growth is not necessarily the best for high yield, so tell us about what’s happened in high yield [debt] so far this year, Olivier.
OM: Things are actually really good in high yield at the moment. Spreads are tighter, which means the perception of investor of risk is lower. Total returns are pretty good, at about 4%. The primary market is making a comeback, which means all companies in our universe can access capital markets again.
And the fundamentals are fairly solid. Results are generally good, and in high yield in Europe, default rates are less than 1%. We had a short episode of volatility – the credit risk collapse – but thanks to the swift intervention from authorities that was quickly resolved and deemed more idiosyncratic than systemic. Volatility came down and spreads came in again.
However, our investors tell us they like credit but prefer investment grade to high yield because of their view of the economy. That’s okay – we are cautious, too. We can wait for the cycle to be more favourable. But we have also been positioning the funds to be more resilient, being slightly cautious and favouring high quality companies, as well as having portfolios that have yields better than the benchmark.
That is what we like about this market – we don’t need to take more risk to get really good yield. You can get a 6%-8% yield at the moment and stay with the better, larger names that can access equity markets and bond markets and most importantly, have ample free cash flow. These are the companies that will be able to pay a coupon of 7%-8% when they refinance their 3%-4% coupon.
We want those companies that have the option to extend maturities should credit conditions tighten further. We think default rates will stay very contained in 2023 because the fundamentals are good – there’s not much in the way of debt maturing – so there’s no obvious trigger for a sudden rise in default rates.
DM: Investing is about risk versus opportunity. The risks at the moment include the debt ceiling debate in the US and the turmoil from the banking sector. What is your team doing in terms of investments given the current risks and opportunities?
OM: We think the biggest risk is that credit spreads, which are already tight, tightens even further. The primary market is opening up, but is really only open to the better companies at the moment. The best credit stories revolve around the balance sheet. Economists are projecting fairly weak conditions by the turn of this year and early next year, so the risk is with the significant amount of HY debt maturing in 2025 and 2026. As these maturities approach, the weaker names will struggle to deal with them and that’s when defaults will start to increase. That’s a risk we see starting in late 2024. It’s something we are positioning for by focusing on the better names, with solid cash flows and companies with lots of options.
However, we also see very good opportunities in three areas. The first is the short-dated maturity. For example, a 2025 maturity, which is two years from now, from companies that are likely to be proactive, manage those maturities by perhaps refinancing and issuing new longer dated debt or some other means.
This is something that is happening now. It means we identify bonds that may trade at 90 to 93 and may have a very low coupon, say, between 2% and 4%. But if those issuers come to the bond market and refinance their bonds, then you get paid back at par, which is an attractive investment return. We’re seeing high single digit or low double digit returns over the next six to nine months, so we like these refinancing transactions.
Another opportunity we see in the market is to capture the very high coupon that some companies are offering on the primary market – anywhere between 6% and 8% for well-run companies with good management and some free cash flow, even after refinancing with more expensive debt. Keeping those 6% to 8% coupons for the next few years is a very attractive trade, even with some volatility in the meantime.
The final opportunity we see, even if it’s a bit early to deploy more risk or capital to it, is something we have to think about because the credit cycle is turning. That will bring more stress situations, more bonds that trade at highly discounted levels because companies are having difficulties or the market is questioning whether those bonds will mature at par.
So we work to analyse the downsides and upsides, and when we think the downside is quite limited, it gives us the opportunity to deploy capital.
DM: What are some of your out-of-consensus views and your key investment ideas?
OM: Where we agree with the consensus is on high quality. We think that’s the way forward, given a more uncertain economic environment and, more importantly, a high interest-rate, high funding environment that may last longer than people expect. The way we are responding to this is by favouring short-dated maturities and the bigger coupons. We think carry will be the bigger component of return, so we’re going for more carry and less capital appreciation. This is how are we going to build portfolios that are more resilient. While we are getting refinancing trades that give us upside potential, we can also progressively reinvest in higher coupon debt.
For example, the telecom sector is an overweight for us, but you don’t want to own everything. In telecoms, there are some capital structures that don’t work in a high funding, high interest-rate environment. We seek to stay with the better names, and if we have the opportunity to get good yield at the front of the curve, then we will favour those bonds. So, we are overweight the telecom sector in terms of market value, but underweight in terms of duration contribution.
Where we are less consensual is on the automotive sector, our second biggest sector. Here, we favour the suppliers because car production has been in recession over the past few years because of Covid and supply problems. Now vehicle producers are recovering, and we expect to see growth in production and margin improvements because the suppliers are working through the recovery with the manufacturers. We are less constructive on manufacturers because they’ve had such a good time over the past few years being able to increase prices by 15% when demand was still very strong. We think that is now behind us and that price elasticity will reassert itself.
Another sector that we think is somewhat less consensual is the gaming sector. We actually think it’s fairly resilient to economic weakness – one of our core names did an initial public offering (IPO) earlier this year and earnings are still quite strong in the sector.
Travel and leisure is also a good place to be. There is a tourism boom at the moment so we want exposure. As with car prices, there might come a point when consumers start to shop around or push back against prices, but we think that’s a few quarters away.
Another sector that’s traditionally been a good haven in an uncertain economic environment is packaging, although we are not so constructive on this because some categories are struggling. There’s some destocking, possible changes in consumer tastes, but also some margin pressure. So, we have very little risk there.
More generally, we think this is a stock picker’s environment and that we have the right set-up to navigate that, because we are getting more resources this year, merging with our colleagues in leveraged loans and creating a much larger leveraged finance group. It means we will have 10 more analysts covering the US and Europe, giving us overlap synergies and more time to look at more opportunities on the primary and secondary markets.
DM: Thank you very much, Olivier.
This presentation includes a discussion on current market events and is not intended as investment advice or an offer of products or services by BNP Paribas Asset Management. Please keep in mind that the information and analysis in this presentation is only current as of the publication date.