European high yield untroubled by default rate spike

The European high yield (HY) default rate spiked higher in May with the largest monthly default volume on record (€6bn). Against the backdrop of an index where spreads are trading back towards their tights of the last three years, that headline might sound confusing, so we wanted to highlight the drivers of this widely expected pick-up and outline our view on the market going forward.

The bulk of the volume was due to the default of French telecoms firm SFR (Altice France), which missed a coupon payment on its unsecured debt during the month, subsequently leading S&P to downgrade the bonds of Altice France Holding (the unsecured entity) to a rating of D. Altice France is one of the largest issuers in the European HY market and has been in negotiations with its creditors since March 2024, when the company announced during its full-year 2023 earnings call that it expected creditors to share the burden of deleveraging its balance sheet.

Bondholders subsequently organised and created a cooperative agreement whereby they agreed to act as a unified front when negotiating with the company. This ultimately led to a restructuring plan that gave the bondholders involved a coupon uplift, a maturity extension, and a slice of the equity. With the 90% approval reached last month, the company will enact the plan with bondholders over the next few months via an accelerated sauveguarde (essentially a fast-track restructuring process in France).

SFR has not been the only large cap issuer going through a distressed exchange, with the likes of packaging firm Ardagh and UK-based utility company Thames Water heading in the same direction. Very much like Altice, these exchanges have been well flagged, with companies and bondholders negotiating the terms for several quarters now. Once these restructuring processes reach an agreement, we think the European HY default rate will peak at slightly above 5% on a notional weighted basis, though it should peak well below that on an issuer weighted basis (given it has been driven by a limited number of large cap credits). Importantly from an index perspective, the exchanges are being done at high recovery rates, with the rate for Altice France secured bonds expected to be around 92% including the equity stake (the unsecured bonds are set to take a much larger hit given a recovery rate in the 20s).

Aside from the names discussed here, European HY fundamentals remain robust. Gross leverage for the sector remains below the 20-year average, while interest coverage has improved in recent quarters and remains around the longer-term average. The distress ratio – which measures the percentage of the index trading above a spread of 1000bp – fell through May to roughly 5%, while bonds trading at a cash price lower than 60 fell to below 2%, suggesting the market is not expecting a pick-up in new defaults in the coming few quarters. This continues to be underpinned by a supportive technical, with resilient flows, limited net supply and steady coupon accrual driving a persistent bid for not just high yield but credit in general.

We believe the default rate will likely peak over the next couple of quarters as storied credits from the last year or two come to an agreement with their bondholders. We also believe this is largely priced in by the market, and so the pick-up in the headline rate should not come as a surprise, particularly as it is driven by a handful of names. While fundamentals remain robust, we view spreads as ultimately well-priced for that strength. There are good opportunities within the space on a selective basis, and our focus is on solid free cash flow generators in mostly non-cyclical sectors, though at present we generally see better risk-reward opportunities in other areas of the fixed income space, including financials and asset-backed securities (ABS).