Despite tight spreads, European HY is not overheating

Tight spreads and elevated supply are often key signs that fixed income markets are overheating. Despite these all being present within the European High Yield market today, the underlying data points to a more measured backdrop characterised by the printing of high-quality new issues, improving credit fundamentals and a stubbornly supportive technical background, offering investors reassurance over the medium-term future of the asset class.

The European High Yield new issue market remained active in the third quarter, with €37bn of issuance helped by the busiest September on record. This follows the €42bn reached in the second quarter, which marked the highest quarterly supply volume on record. At the same time, European HY spreads reached their tightest level in almost 8 years in August at +272bps. With such strong issuance trends and spreads hovering at near post-GFC tights, it is natural for investors to question whether the market is starting to overheat.

Looking at the data, we do not think this is the case. Although gross supply might be breaking records, net supply is not. Net supply in the third quarter was just €6bn after substantial redemptions by issuers, signalling the market is far from flooded. More importantly, the quality of new issuance is improving, with BB rated bonds accounting for 62% of activity in Q3 – the highest share since late 2023 – and only one CCC-rated deal being launched thus far this year. Leverage metrics only reinforce this trend, with new issue HY bond leverage having dropped to just 3.5x and the share of “credit negative” issuance (new issues where the credit profile deteriorates a result of the transaction) running at 27% YTD according to JP Morgan – the lowest level since 2020.

Despite starting the year at tight levels relative to historical averages, European HY spreads have rallied a further 50bps since January. Given the aforementioned deluge of supply we have seen, such tightening has been aided by the incredibly strong technical backdrop - fuelled by €7.8bn of inflows from clients into HY-dedicated funds. We note that the primary issuance continues to be well digested by investors, evidenced by a consistent theme of over-subscribed order books and sizeable tightening from initial price talk (IPT). We expect this to continue for the foreseeable future given the elevated average cash position amongst HY funds, which Spread Research estimates to be €18bn, or 5%. Sticking to the theme that the market is not overheating, it is important to highlight that HY investors have remained selective over where they allocate their cash. The spread rally has been quality-led, with BB spreads having compressed while CCCs have widened, implying a disciplined investment approach rather than a speculative frenzy.

The behaviour of green bond issuance within the market provides yet more evidence of a lack of overheating. Green, Social and Sustainable issuance as a proportion of total European HY supply has fallen this year to 11%, the lowest level since 2020. This trend is not a sign of waning demand but rather reflects heightened investor scrutiny. Asset managers are conducting more detailed ESG assessments and increasingly placing capital with companies who can demonstrate higher quality ESG track records, implying the market is naturally experiencing a more genuine and possibly longer-lasting “greening” effect. The reduced volume of green issuance underscores the maturity and discipline within the market, serving as another signal that activity is appropriately grounded.

To bring some balance to the argument, the one area showing exuberance is dividend recapitalisation activity, which reached €29bn YTD across loans and bonds in September, already a record figure with three months of the year still to go. This type of transaction often carries a negative reputation among bond investors as they involve companies raising additional debt to pay dividends directly to shareholders, essentially extracting value from creditors to benefit equity holders. We view such deals with a degree of caution given their re-leveraging properties, which sometimes result in ratings downgrades, but strong investor demand will help to align dividend recap activity with sustainable credit profiles and fundamentals, thereby preserving overall market balance. As we have highlighted previously, the volume of dividend recap deals have exceeded expectations this year and it is an area we are closely monitoring.

Despite signs that might typically suggest overheating, the underlying data suggests that the European High Yield market remains fundamentally healthy. Strong issuance volumes are accompanied by improving credit quality, conservative leverage levels, and a disciplined investor base, factors which resemble a well-balanced market. Whilst we are encouraged by how well the asset class is performing and are satisfied with its current state, we remain selective, focusing on investing in businesses with strong balance sheets and robust cash flow, particularly given the uncertain global geopolitical and macroeconomic environment which persists.