Investors demand highest premium in years to hold risky European debt

Europe’s riskiest corporate borrowers are paying the highest premium in seven years to tap the region’s €412 billion junk bond market, highlighting growing fears that a long period of high interest rates and an economic slowdown could trigger further defaults.

The so-called “spread” – or gap – between the yields on euro-denominated corporate debt rated triple C or lower and government paper has widened to more than 18 percentage points on average, according to an ICE Bank of America index.

That marks the biggest spread since June 2016 and surpasses levels seen in 2020 when the Covid-19 crisis triggered fears of messy defaults and bankruptcies. At the start of last year, the spread was as low as 6.7 percentage points.

Government bond yields have soared on both sides of the Atlantic in recent weeks, dragged skywards by concerns that both the Federal Reserve and the European Central Bank will keep interest rates ‘higher for longer’ to get inflation under control. But corporate bond yields have climbed at an even faster pace.

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Expanding spreads indicate that bondholders are demanding larger premiums to compensate them for the risk of a default.

European companies that have defaulted on bonds or loans in recent months include French retailer Casino Guichard-Perrachon, Netherlands-based manufacturer Keter and Belgium-based Ideal, according to ratings agency Moody’s.

Analysts and investors said the widening of risky European spreads underscored persistent concerns over the health of the region’s economy. They also pointed to structural issues within Europe’s high-yield bond market – including its lack of depth and liquidity – which have fuelled sharper moves than those in the same asset class in the US.

“I think the economic backdrop in Europe is definitely worse than in the US,” said Christian Hantel, a corporate bond portfolio manager at Swiss firm Vontobel. The widening of spreads “has to be seen in the context of slower economic growth, the aggressive interest rate hikes and the ongoing elevated inflation numbers”.

Many more North American companies have defaulted on their debt so far this year compared with Europe. Spreads for triple-C rated bonds in the US have also yawned wider since the end of the summer, as markets have increasingly priced in expectations of interest rates staying elevated well into next year. But they remain tighter than their European counterparts at roughly 10 percentage points, around levels seen just a few months ago.

Very low-grade European borrowers also suffer from having a narrower investor base than their counterparts in the US, where the high-yield bond market is $1.3 trillion (€1.1 trillion) in size, say analysts.

“Europe has a bank-based financial system. The US has a market-based financial system,” said Torsten Sløk, chief economist at Apollo. “There’s much fewer places to go in Europe – you can really only basically go to the banking sector, because credit markets just play a much smaller role.”

That relatively small market size also allows for individual credits to have a disproportionate influence over the direction of an index or subindex.

A bond issued by the heavily indebted French telecoms group Altice, yielding 29 per cent and maturing in May 2027, has the largest weighting in Europe’s triple-C high-yield gauge, at 4.7 per cent. Its spread has widened to more than 28 percentage points from less than 26 percentage points in late September, Bloomberg data shows.

“Idiosyncratic names [can] push the [index’s] spread out,” said Anton Dobrovskiy, investment specialist on the euro high-yield team at T Rowe Price, adding that risk aversion linked to the Israel-Hamas war was also likely to have amplified moves in European credit spreads this month.

Times of market and economic uncertainty typically hit the lowest-grade companies hardest, noted Vontobel’s Mr Hantel.

“Triple-Cs are the weakest link of the high-yield universe and the corporate credit market in general,” he said. “It’s not a surprise that we see more stress here.” – Copyright The Financial Times Limited 2023