"WITH YIELDS SIGNIFICANTLY HIGHER, WE EXPECT ONLY A SLIGHT INCREASE IN THE DEFAULT RATE."

Felix Fischer on the current positioning of EUR high yield companies, the expected default and recovery rates and his top 3 HY picks for 2024.

Felix Fischer is Global Head of Research and Head of Europe at Lucror Analytics, a leading credit and ESG research specialist based in Singapore. Fischer started his career at DEKA in Frankfurt and subsequently worked for HypoVereinsbank (Unicredit) in Munich, Lehman Brothers in London and PIMCO in Munich. He is one of the founding members of Lucror Analytics and has been working for the company since 2010, focusing on high yield research.

Mr. Fischer, let's start right away with a stocktaking on European High Yield, one of FAM's investment focuses. How did 2023 go in terms of new issues?

In 2023, we saw a significant increase in new issues compared to 2022 (over 40%). However, the volume was still very significantly below that of 2019-2021. A good proportion of new issues were used for refinancing, whereas the number of financings for leveraged buy-outs, dividend distributions or recapitalizations was low. This was due to a relatively low number of private equity transactions on the one hand and an increase in alternative financing on the other. In this context, private credits are gaining in importance. For example, the planned acquisition of the Norwegian online platform Adevinta is expected to be financed with the help of a private loan in the amount of EUR 4.5 billion, which would represent a record for private credit. Overall, the outstanding volume of the European high yield market has shrunk by around 10%.

What can be said about the defaults?

The default rates for European high-yield companies have risen slightly from just under 2% in 2022 to around 3%. The most prominent default was probably that of the French retail group Casino, which is currently trying to restructure its debt. Overall, 2023 was a good year for investors with an average return of around 11%. This roughly corresponds to the loss in 2022.

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The figures for companies in the Building Materials & Construction segment, which are heavily dependent on new buildings (e.g. Consolis), were disappointing. However, companies that generate their sales mainly from renovation/infrastructure were able to buck this trend and perform better. Furthermore, and surprisingly for us, some pharmaceutical companies, particularly in the area of medical tests, have also disappointed. There have also been some negative rating changes here (e.g. Biogroup and Cerba). It was not possible to adequately compensate for the decline in sales due to falling Covid tests. TMT companies (technology, media and telecommunications industry) also fell slightly short of our expectations. The main reason here was inflationary cost pressure. Other cyclical sectors such as chemicals and shipping were also weak, although this was in line with our expectations.

On the other hand, some companies in the consumer goods sector delivered very solid figures, some of which exceeded our expectations. Strong results came from the Capital Goods sector, for example. Here, companies benefited from a high order backlog and declining cost inflation, which has not yet been fully passed on to customers.

Let's take a closer look at a few points. So the defaults have remained within limits, which initially seems surprising in view of the weakening economy and the enormous rise in interest rates. What is the reason for this?

The relatively moderate increase is partly due to the manageable maturities in 2023. In addition, many companies have positioned themselves well to be able to cushion an economic downturn. In this respect, some companies have of course learned their lessons from the Lehman crisis after 2008 and the effects of coronavirus. You also have to bear in mind that companies that issue high-yield bonds are generally relatively large, well-positioned companies that are often among the global market leaders in their respective sectors. We are not talking about small companies here, which have a much thinner financial base and are more susceptible to an economic downturn. Apart from that, most investors try to avoid defaults in their portfolios as far as possible. In this context, some of the weaker companies - also with the consent of investors - have swapped their respective maturities for bonds with a longer term or made an adjustment to the final maturity of the respective bond. I think we will see an increasing number of maturity extensions by weaker companies.

Will there be more bankruptcies in 2024?

There will probably be a moderate increase in defaults for EUR high yield issuers. However, we do not expect it to be significantly outside the 2-5% range we have seen since 2010. In this we agree with the opinion of the rating agencies, which expect a moderate increase in default rates. For example, Fitch expects an increase to around 4% in the base case and 6% in a stress scenario for 2024. The only moderate increase despite difficult economic conditions is due to the relatively good condition of most companies and their still acceptable financial ratios. In addition, S&P estimates the refinancing requirements of European high-yield companies for 2024 at just USD 68 bn, which is also relatively moderate. Apart from this, only a very small proportion of the companies that need to refinance are rated worse than "B-". However, the refinancing requirement will increase significantly in 2025 (USD 153 bn according to S&P estimates) and 2026 (USD 232 bn). If the economic downturn continues for longer, this could become a problem in the future.

You mention the rating agencies. There was recently a much-noticed research report from Fitch in which the rising "base interest rates" were addressed, especially for companies with a rating of single-B or worse. Do you also see a significant risk in the rising interest rates and does this exist above all where, in addition to HY bonds with fixed coupons, loans, which almost always have variable interest rates, also play a significant role?

The rise in interest rates could become a problem for weaker companies in the medium term, particularly as hedges that some companies have used to protect themselves against rising interest rates are also expiring. In the last twelve months, companies' interest cover has therefore deteriorated - in contrast to their debt-to-equity ratio, which has remained relatively stable. The current average interest cover for the companies we analyse at Lucror Analytics is around 4.3x compared to around 4.9x twelve months previously. Issuers therefore have to use a larger proportion of their cash flow to pay interest, which on the other hand also leads to increased motivation to reduce debt and may have an impact on expansion plans and distributions to owners.

Fitch assumes that if interest rates remain stable, around a third of "B" rated companies will have problems covering maintenance investments and interest with EBITDA. Statistically speaking, this may of course be true, but Fitch does not take into account the fact that many companies also have the means to take countermeasures and reduce debt, for example by selling assets or parts of the company, raising equity, factoring or temporarily reducing maintenance capex (replacement and maintenance expenses).

Three years ago, you said in the same place: "I don't expect a wave of bankruptcies". This statement sounded very bold at the time and contradicted mainstream opinion, but proved to be absolutely right. Would you still take the same view today - despite the additional burdens you described?

We still do not believe that there will be a significant wave of bankruptcies. However, a moderate increase in payment defaults in 2024 - as already mentioned - seems entirely realistic. The creditworthiness of companies has remained relatively stable overall.

If there is a default, it is all about the recovery rate, i.e. how much is left for investors. Historically, this has been around 40%. Is this rate still plausible or does it need to be adjusted downwards? The few bankruptcies in 2023 were not a good omen in this respect.

This depends on the industry in question, the terms of the bond (collateralisation, ranking), the legal framework to which the company is subject, and so on. As a rough average, however, the 40% should hold, although there may of course be outliers at the top or bottom. However, the increasing softening of bond conditions (covenants) is proving to be less favourable from an investor's point of view. This leads to a worse position for creditors in the event of restructuring. In addition, issuers are less restricted in terms of distributions to equity providers or M&As.

Let's look ahead. What do you expect from 2024? What returns are possible? Where are the biggest risks lurking?

Following the year-end rally, especially on the bond and credit markets, we consider the European high-yield market to be fairly valued. We expect 2024 to be a solid year. We believe that a return in the mid to high single-digit range is possible (roughly in line with current yields). Risk factors are undoubtedly a stronger than expected economic downturn, a lack of easing on the interest rate side and geopolitical risks, such as an escalation of the conflict in Israel or Ukraine. The US elections will keep the markets busy from the second half of the year at the latest. It seems entirely possible that Donald Trump will take the White House for a second time, although this will not necessarily have a negative impact on the high-yield markets. However, volatility could increase in the second half of the year.

As an HY research house, you at Lucror have a good overview of the investor base in the European HY market. How has the number of dedicated HY investment funds developed over the last ten years? And what are your expectations for the future?

Over the past ten years, the number and volume of European high-yield bonds has increased overall and, accordingly, more dedicated high-yield funds are active on the market. However, development has stagnated in recent times. In our opinion, there will continue to be new HY funds, but there will also be an increasing focus on alternative instruments, such as loans or private credit. We see high growth potential in the private credit segment in particular, which should also lead to an increase in the number of funds.

Felix Fischer's top 3 HY picks for 2024

Although we consider the market to be fairly valued overall, there are of course attractive investment opportunities:

1. International Personal Finance grants consumer loans to people who generally do not have access to the banking market. IPF has a solid financial structure and is relatively diversified. We also believe that the company is well managed. The 9.75% 11/25 bond (WKN A2843L) yields around 11%. We think that IPF will refinance in 2024 and consider the current yield to be attractive.

2. We also find the Klöckner Pentaplast bonds interesting. The company is a leading provider of rigid and flexible packaging and speciality film solutions for pharmaceutical and medical products, food, beverages, etc. Although the short-term outlook is difficult, the company is well positioned and the credit profile should improve in the medium term as a result of some growth investments and measures to reduce the cost structure. We like the Senior Secured Bonds with a coupon of 4.25% and maturity 03/26 (WKN A3KLPG). The yield is currently around 13%. We also consider the 6.5% bond maturing 09/26 (WKN A3KLN8) to be an interesting speculative investment. This bond yields around 32%, but should only be considered by investors with a high risk appetite should consider it.

3. In our view, the yields on bonds issued by the Polynt Group, a speciality chemicals company, are also attractive. The company has recently performed well compared to its competitors and has impressed with relatively stable margins. Polynt also has high liquidity and a solid cash flow. The 9.5% 07/28 bond yields around 7%.

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Source: Bloomberg, FAM