3. The European high-yield market stands out for its higher quality profile, and we do not see a default cycle on the horizon.
In addition to being much larger than it was 10 – 20 years ago and offering investors a significantly wider opportunity set, today’s European high-yield market has seen a steady increase in quality. Currently, over two-thirds of the market, as measured by the ICE BofA Euro High Yield Constrained Index, is rated BB, and only approximately 6.5% is rated CCC and below2. When we combine the higher quality composition of the local market relative to past cycles with the fact that corporate fundamentals remain robust, we do not believe a full-scale default cycle is on the horizon. Instead, we think European default rates are likely to stay close to their long-term averages over the next 12 months. We’re also seeing the high-yield market be more disciplined than in the past — many deals that have come to market haven’t been funded in the high-yield market but have instead gone to other markets, such as private credit.
Where are the risks and opportunities in 2025?
While we believe European high-yield valuations look attractive relative to the US, tight spreads call for investors to be prudent decision-makers. One of our overarching beliefs is that the high-yield market is highly inefficient at pricing default risk — implying the need for deep, fundamental research. In 2025 and beyond, we’re watching the following themes, which we think present active investors with both risks and opportunities.
Europe could face US tariffs…but not all sectors and issuers will be affected equally
The geopolitical backdrop remains complex and uncertain. We think investors need to reposition for potentially greater dispersion across sectors and issuers, particularly in the context of the threats that US President Donald Trump’s planned tariffs could pose. This is where we believe sector- and issuer-level analysis plays a key role. The European high-yield market is typically very domestically focused, with large sectors such as utilities and services supplying their local regions. We believe certain sectors, such as the automotive and basic industry sectors, are more exposed to tariff risk, meaning caution is warranted. On the other hand, sectors where there is a lower level of competition, such as supermarkets, may find themselves in a stronger position to pass through to end consumers the additional costs from tariffs. This could mean that certain issuers are likely to see only a limited impact on margins. In our view, this makes it even more important to prioritise companies with sustainable competitive advantages.
Another DeepSeek-level event could shake market conviction in AI…making it prudent to avoid sectors with increased capacity
AI is, of course, enabling an exciting new phase in the ongoing technological revolution, with potentially promising new applications across society. But predicting who will be the winners and losers of the AI boom is far from straightforward and there will inevitably be instances of misdirected capital. We’re wary about the significant levels of above-trend investment and capex and the resulting potential for a bubble to form given the enormous level of borrowing seen in the industry. As such, we remain doubtful about the prospects for high-yield companies with high exposure to the AI theme, for example, utility companies that are providing the underlying infrastructure required to expand AI capabilities. However, within technology more broadly, we see a number of opportunities in payment providers and software services companies with strong competitive advantages like the high expense of changing suppliers.
Market volatility could continue and spreads could widen… giving high-yield investors the opportunity to potentially generate alpha from valuation opportunities
While high-yield bonds can continue to offer attractive coupon payments, tight spreads reduce the scope for capital appreciation. However, if volatility in fixed income markets continues, we may see a return to spread dispersion in the market. In our view, this may provide the potential for active investors to generate alpha from valuation opportunities. In this environment, we think it’s possible for active managers to add value over benchmark indices through bottom-up, fundamental credit selection.
How high-yield investors can benefit from volatility
We believe the environment for high-yield bonds will present attractive income opportunities for investors over the next 12 months, with active managers potentially best positioned to benefit if we see a return to interest-rate volatility. We favour European over US high yield given its greater income potential and higher-quality bias. From a longer-term perspective, we view high-yield investments as continuing to play a crucial role in diversifying and enhancing bond portfolios.
