Sandrine Soubeyran
Robin Marshall
- Eurozone HY (EHY) outperformed other credit classes and joined long-dated government bonds in the top 15 performance table.
- This occurred despite higher ECB rates and very weak Eurozone growth.
- Strong correlation with equities, and spread compression drove the rally, but is EHY relative value now less attractive?
High yield credits were among the best performing fixed income assets in 2023, despite very weak growth in some regions. Risk appetite returned in the last quarter of the year, buoyed by lower inflation and optimism on policy easing. Median Fed “dot plots” from the December FOMC showed 75bp in easing by the Fed in 2024. In addition, as Chart 1 shows, the positive mood resulted in markets ‘front running’ the Fed, and other central banks, and anticipating policy easing. Re-investment risk may also have helped boost purchases in longer government maturities, where extra duration improved returns.
Table 1: HY credits join long governments in the Top 15 performance table in 2023 (in euros, TR, 12M).
Source: FTSE Russell, an LSEG Company, 1Y to December 31, 2023, total return, in euros. Past performance is no guarantee to future results.
Euro HY credit outperformed IG credit in 2023, as spreads tightened sharply.
While returns for investment grade (IG) corporates were up a solid 1-6% in euro terms in Q4 2023, and 4-8% in 2023, they trailed those of high yield (HY) credits and were largely coupon driven. Euro High Yield (EHY) credit emerged as the star performer within corporates bonds, after gaining nearly 6% in the last three months of 2023, and 13.4% on 12 months, in euros, while returns for their EM and US HY equivalents were reduced by the strength of the euro (see Table 2).
Table 2: Corporate bonds rallied further in Q4 2023 as risk appetite improved.
Source: FTSE Russell, LSEG, -3M and -12M to December 31, 2023, total return, in euros. Past performance is no guarantee to future results.
Eurozone High Yield shows a steady decline in all sector spreads in 2023, which combined with lower Bund yields, drove the strong performance returns. However, the Energy sector stands out on spreads, although it represents about 2% of the EHY market weight, since they fell from about 800bp at the beginning of 2023, to around 400bp at the end of December, as energy supply recovered.
Chart 1: Euro high yield sector spreads drop sharply in 2023.
Source: FTSE Russell, an LSEG company, as at January 2024. Past performance is no guarantee to future results.
Widespread sector gains in EHY of over 10% in 2023
Chart 2 shows the returns for the same EHY sectors as in Chart 1, and unsurprisingly, Energy dominated the performance table, with the Consumer sector emerging in second position. But gains were consistent across the asset class, with a performance of over 10% for the year in euro terms, complementing Energy and Consumer sector returns of over 20%.
Chart 2: Energy and Consumer sectors dominate the EHY performance in 2023.
Source: FTSE Russell, an LSEG company, as at December 31, 2023, total return, in euros. Past performance is no guarantee to future results. Please see the end for important disclosures.
EHY manufacturing and services credits performed strongly despite weak growth
Key sectors to note are Services and Manufacturing. These sector heavyweights account for over 50% of the Euro high yield market (Table 3). Although the Services sector spread only fell 50-70bp over the last twelve months, it nevertheless gained nearly 12% in 2023, due to the combination of lower Bund yields and the spread compression. Similarly, Manufacturing, with a sector weight of nearly 25%, also performed well, despite very weak growth.
Table 3: Services dominate EHY market by weight, followed by Manufacturing.
Source: FTSE Russell, an LSEG company, as at December 31, 2023. Past performance is no guarantee to future results. Please see the end for important disclosures.
Also to note, high yield credit issuers are rarely able to borrow in longer maturities, so HY indices tend to have shorter duration than IG. HY duration shortened further in 2022, as yields rose. As Chart 2 shows, the European IG corporate bond market (EuroBig index) is about twice as long in duration as that of its Euro high yield equivalent, even after losing about one year each in duration since the end of 2019. The lower duration for the EHY brings an element of ‘defensiveness’ compared to IG corporates, and lower credit quality means that EHY is more highly correlated to European equities than IG corporates.
Chart 2: Euro HY modified duration returns to pre-Covid level.
Source: FTSE Russell, an LSEG company, as at December 31, 2023. Past performance is no guarantee to future results. Please see the end for important disclosures.
As a result, the strong performance of Developed Europe (ex UK) equity markets in 2003 was another key driver of HY returns in 2023, with equity market gains of about 19%. Indeed, the combination of lower Bund yields, attractive relative valuation versus IG credit, and stronger equity markets created favourable conditions for EHY in 2023, despite weak Eurozone growth and ECB policy tightening.
After a strong EHY performance in 2023, much depends on the nature of the ECB pivot
The key issues in 2024 for EHY are likely to be the timing and drivers of an ECB pivot to ease policy. ECB President Lagarde remains cautious, signalling at the Davos Summit a possible easing only by the summer, while wage growth remains high, and inflation above the 2% target. An easing move will be “data-dependent” and not “time-dependent”, as the ECB awaits a softening in wage growth and core inflation, which was 3.4% y/y in December.
Another complexity is balance sheet normalisation or Quantitative Tightening (QT). The ECB no longer re-invests maturities from the Asset Purchase Programme, but fully re-invests maturities from the pandemic emergency purchase programme (PEPP) until mid-year, and then plans to under-invest maturities by €7.5 billion monthly, before ending PEPP reinvestments completely at the end of 2024. Although the relationship between QT and rate moves remains fraught, it may wish to offset the impact of faster balance sheet contraction from mid-year by easing rates, since it has made clear policy rates are the key monetary policy instrument. However, an alternative would be to defer QT, which would also be an effective policy easing.
EHY spreads normalised versus IG, so the relative value case is not as strong as 2023
An earlier pivot from the ECB, driven by a deepening recession, might well drive EHY underperformance and spread widening. But a later pivot from the ECB, driven by a softer landing for growth and inflation, could drive further HY gains and spread tightening. Also note, that after the outperformance of 2023, HY credit spreads have normalised versus IG credit, benchmarked by historical spreads (see Chart 3). With lower default risk, IG credits are also less exposed to outright recession risk than HY, and more closely correlated with government bond yields, should Bund yields fall further.
Chart 3: Euro HY spreads have normalised since the Covid peak.
Source: FTSE Russell, an LSEG company, as January 2024. Past performance is no guarantee to future results. Please see the end for important disclosures.
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