European HY offering margin of safety after 2018 turbulence

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European high yield spreads almost doubled over the course of 2018, in an environment of heightened market volatility and challenging idiosyncratic developments.

Like most asset classes last year, European high yield was not immune to growing investor concerns surrounding issues such as geopolitical turbulence, the supportiveness of central banks, lower energy prices and a slowdown for the global economy.

There were also three major idiosyncratic factors impacting European high yield. Firstly, the disruption in e-commerce continued to cause weakness for retail names. In addition, negativity surrounding emerging markets hit companies with large exposure to the developing world. Finally, companies in troubled Italy, as well as other parts of southern Europe, also came under pressure.

Improved margin of safety
Even though spreads have come down from more than 5% to about 4.4% so far this year, the asset class still offers a far higher margin of safety than at any time since the middle of 2016. This increased margin of safety comes at a time when credit quality in the European high yield market remains reasonable.

In fact, with a historically-low default rate of just 0.4% in 2018, the European high yield market appears relatively attractive in comparison to its US counterpart, where the default rate was 2.3% last year. The quality of the US high yield market is also generally lower than in Europe.
Leverage levels for the European high yield market are well below the lead-up to the financial crisis, while interest rates are significantly lower. The combination of satisfactory leverage levels and low interest rates provides a lot of head room for companies in respect to interest payments. Profitability would have to be significantly squeezed before corporates struggle to meet payments. This dynamic is likely to keep interest rates quite low for the foreseeable future.

Remaining cognisant of risks
Naturally, we remain vigilant regarding the ongoing uncertainties surrounding Brexit. The UK's exit from the EU has caused us to be quite conservative in relation to UK companies we invest in. To this end, we have targeted domestic opportunities with lower exposure to a potential negative Brexit outcome - primarily stable credits like water companies, other utilities and airport groups.

We are also keeping a close eye on other developments in Europe, particularly with the populism trend still evident across the continent. Italy, for example, is actually weaker economically than the UK. It is important to understand what the implications may be for the European high yield market.

More broadly, we continue to run an overweight position in senior secured credit, which offers stronger downside protection if we see a deterioration within the market. We also have a conservative approach in relation to country exposure - with a preference for markets in Northern Europe, away from the negative trends we are witnessing in Southern Europe. Finally, as the cycle extends into its latter stages over the coming years, it is more prudent to have overweight positions in stable industries, such as healthcare, over the more cyclical spaces.

Sandro Näef, portfolio manager of the Nordea 1 - European High Yield Bond Fund