In recent weeks, surging natural gas prices across Europe have raised concerns about inflation, negative impacts on consumer spending and overall corporate profitability. The rise in prices has been breath-taking, with natural gas soaring from €20 per megawatt hour at the start of May to €138 per megawatt hour in October1. However, we do not believe that these price increases portend a coming default cycle in the European high-yield market. In fact, we believe that the recent spread widening, which has taken spreads to around 100 basis points (bps) wider than the recent tights in 20172, has created an attractive buying opportunity for investors looking for both income and total return.
While inflation has now reached 3.4%3 in the eurozone, and we believe it could go higher in the short term, it remains unclear how persistent inflation will be in the longer term. Even if this inflation risk were to materialise and be accompanied by higher interest rates, we would note that high yield has historically been largely insulated from movements in rates, as Figure 1 shows. By contrast, rate movements are a much bigger factor in the performance of higher-quality investment-grade corporate and government bonds.
In the table, we calculate the years of income required to offset a 25 bps increase in core rates between European investment-grade and European high-yield indices. Compared with investment grade, high yield offers a 2.4% yield pick-up, while also being 1.75 years shorter in duration. Assuming constant spreads, an investor in European investment grade would require more than three years of income to break even from the principal loss caused by a 25 bps rate increase, whereas an investor in European high yield would need a little under four months. This highlights that European high yield’s combination of shorter duration and higher coupon income can be highly beneficial in insulating investors from upward movements in core rates.