Is there value in the troubled European chemicals sector?

Is there value in the troubled European chemicals sector?

As active managers we are naturally looking for bonds that we believe are mispriced, therefore offering attractive risk-adjusted carry or, sometimes, a capital gain if market pricing falls into line with our view. Equally important is to avoid sectors facing structural or protracted cyclical downturns where we don’t think valuations reflect the fundamentals.

As fixed income investors, we never lose sight of the fact that the best outcome is to receive coupons and principal back in a timely manner. Our upside is therefore capped, while the downside in case of an increase in defaults in riskier assets is potentially large, and difficult to make up for with other positions that can only deliver their coupons and principal.

One sector that has been drawing scrutiny for some time is the European chemicals sector. This is a cyclical industry by nature, where demand tends to rise and fall with the overall economy. Chemical production also uses a lot of energy, therefore access to cost-competitive energy is essential for profitability.

Pricing power varies between producers

The industry can be divided into two parts. The first is commodity chemicals, which are mass produced and standardised, and therefore interchangeable between suppliers. The most common examples are petrochemicals (e.g. PVC and ethylene), which are essentially plastics, with a wide range of applications particularly in construction, manufacturing and automotive. Due to the lack of differentiation in this sub-sector, competition is intense and customers can easily switch suppliers, which causes prices to fluctuate quickly depending on costs and supply/demand dynamics. Margins therefore largely depend on sales volumes and managing costs.

The second is specialty chemicals which are produced for specific end uses such as paints, fragrances, or water treatment. These are generally manufactured in smaller quantities with more differentiation between suppliers, allowing producers greater pricing power and steadier margins. As in commodity chemicals, key end markets include construction, manufacturing and automotive, where demand is sensitive to changes in sentiment, but also more niche uses such as aerospace and pharmaceuticals where demand is more stable.

Tough conditions hit weaker HY issuers

The chemicals sector has generally been weighed down by weak macroeconomic conditions and depressed industrial sentiment since Russia’s invasion of Ukraine in 2022. The European economy took a hit, particularly Germany, and while the services sector bounced back relatively quickly, manufacturing remains subdued. The addition of tariff uncertainty has prompted further caution from producers’ corporate customers, who are taking “wait-and-see” approaches to new projects. Soft volumes, profit warnings and guidance cuts were the prevailing theme of the recent round of results. Commodity chemical markets such as petrochemicals have borne the brunt of the pressure given their more cyclical demand trends, while specialty chemicals have proved more resilient.

The picture is particularly tough in the European high yield (HY) space, where smaller, less diversified issuers face weaker balance sheets and limited flexibility. We have seen widespread cost-cutting initiatives as companies look to mitigate cash burn. However, chemicals remains a capital-intensive business, and capital expenditure can only be brought so low before the reliability of assets is put at risk.

The case of PVC producer Kem One showed how quickly technical issues can turn a challenging situation into a stress scenario. A weakened balance sheet on the back of prolonged weak conditions in the PVC market, paired with several operational setbacks, saw the company's liquidity cut in half in the space of just one quarter. With PVC margins still depressed and no recovery in sight, its €450m November 2028 senior secured bonds are currently trading at a cash price in the low 30s.

Demand recovery remains elusive

The long-promised chemicals demand recovery, which firms initially expected in late 2023, has been pushed out again and is now expected in 2027, as has been communicated by several companies including major petrochemicals producer INEOS Group. Petrochemicals markets have been facing a challenging combination of persistently weak demand and structural oversupply, exacerbated by capacity increases in Asia. Europe also faces the added burden of high energy costs and carbon taxes. For INEOS, pressure in Europe has been partly offset by stronger performance in North America, thanks to its cost advantage. However, we are now seeing early signs of weakness with tariffs clouding sentiment (US labour market data busts benign macro narrative). Thanks to its scale and financial flexibility, INEOS is arguably better placed than most of its HY peers to cope with the challenges. However, things are likely to get worse before they get better for its credit metrics, as evidenced by Fitch downgrading the business to BB- on Tuesday morning. 

As a cyclical industry, the chemicals sector ultimately needs a broader industrial recovery to improve the prospects for its producers’ customers. The European Union’s “ReArm Europe” plan may provide a catalyst, with defence spending set to rise from 2.1% of GDP in 2025 to 5% by 2035, with Germany alone boosting outlays from €62bn to €152bn by 2029, enabled by its debt brake reforms. Yet the economic benefits of this shift are unlikely to materialise meaningfully until after 2027 (KPMG expects a 0.9 percentage point boost to Eurozone GDP in 2027, assuming spending is front-loaded). In the meantime, headwinds continue to pile on: tariffs, weakening US sentiment, energy risks, and ongoing geopolitical uncertainty. Just last week, the US reportedly proposed broad G7 sanctions on Russian energy in a bid to end the war in Ukraine. While an end to the conflict would no doubt greatly benefit the wider economy, an uptick in energy prices would be a source of significant pain in the near term for Europe’s industrial sectors, which already suffer from a cost disadvantage.

Premiums don’t look compelling enough

The key question for sectors going through challenging cycles is not only whether earnings have yet bottomed out, but also how long the bottom might be. Identifying potential winners is a case of assessing which companies will be able to maintain enough liquidity to survive until a demand recovery materialises.

We don’t see the situation for chemicals names stabilising at this stage, and while yields on riskier euro HY chemicals bonds have widened substantially year-to-date, for now, we do not find the risk premiums compelling enough given how far away that recovery still looks. In the meantime, we can expect to see a few more rating downgrades and potentially defaults along the way. In the current environment, we think there are safer ways of obtaining an attractive level of income.