A guided tour of the European High Yield market

As my esteemed colleague Stefan pointed out earlier this year, we are beginning to see some attractive value emerging in the European high yield market. I thought it would be worth giving a quick update on what is being priced in and also peel back the lid on the market and take a peek inside at some of the individual high yield issuers lurking within.

Let’s start with the overall market. As of 7th September one of the main European high yield cash indices* was offering an overall gross redemption yield of 10.2%, or an additional yield of 8.9% over government bonds. Another oft quoted and traded index (the iTraxx Crossover 5-Year Index) recently traded over 750bps. Wonderful – but what does this actually mean?

At that level, the market is pricing in a 47% default rate over a 5 year period **. That means, if the market is correct, almost half of all the members of the European high yield market will slip into bankruptcy by 2016.

In my view this is an overly pessimistic view of the future, particularly when we take a look at some of the companies that this index is based on. Of course, we may not be at the lows for the European high yield market. Calling the exact bottom of any market is something only the very brave and/or foolish would do, and further problems within the Eurozone could well push the market further into the mire, but I’m willing to put my head partially on the block and state the view that we are firmly in “cheap” territory here.

Let’s take a look at some of the companies that issue high yield debt in Europe. (Full disclosure: M&G funds own bonds issued by all the companies mentioned below)

Ineos is one of the largest chemicals companies in the world with annual turnover in excess of €20bn. It is an international player with plants in North America and Europe. The company recently sold a stake in its refining business receiving $1.015bn in cash.

Capsugel was spun out of the US pharmaceuticals giant Pfizer earlier this year. The business is the global leader in the manufacture of hard gelatin capsules, selling its products to the pharmaceutical industry across the world.

Sunrise Communications is Switzerland’s second largest telecommunications company.  It offers land line, broadband and mobile phone services to consumers and businesses.

Ardagh Group is an international consumer packaging company with annual turnover of around €3bn. The group operates in Europe, the US and Asia. Its main focus is food and beverage packaging, both glass and metal.

Unitymedia is the largest cable television operator in the German states of Hesse and North Rhine Westphalia, some of the most densely populated and wealthiest regions in the country.

I think it’s fair to say that these (admittedly highly subjective and cursory) examples are sensible companies with robust business models, physical assets, and in many cases would be considered “blue chips” if they were publicly listed. They are not immune to the cycle and they are all, to some extent, highly indebted, but I still think that at current yields we are being handsomely compensated for this.

Finally, it’s also worth pointing out what these businesses are not: i) They are not banks requiring large injections of capital to survive ii) They are not overly indebted sovereign nations and iii) They are not dependent on the so-called “periphery” economies for cash flow and earnings. All these are important considerations for anyone investing in the European credit markets right now.

*Merrill Lynch Euro High Yield Constrained.
** Bloomberg , assuming a 40% recovery rate.