As Covid-19 swept through the Western world triggering havoc in markets and then economies, default expectations in European HY soared, with market levels implying four in every ten companies would default over the next five years. But fast forward to the end of the year and, on a par-value basis, European defaults have hit just 3.6 per cent of outstanding loans over the past 12 months, while Euro currency defaults are even lower, below 2 per cent. Longer-term cumulative default rates have hardly moved (see chart 1). So what has made this credit cycle different, and will there be a default backlash in future years?

‘Whatever it takes’ 2.0

In March 2020 when German finance minister Wolfgang Schulz unveiled his government’s Covid response rescue programme, he announced: “This is the bazooka, and we will use it to do whatever it takes”, echoing the ‘whatever it takes’ uttered by European Central Bank (ECB) president Mario Draghi in relation to the response to the European sovereign debt crisis in 2012. Days later, French President Macron announced: “No business whatever its size will face risk of bankruptcy.” 

Investors paid scant regard to these comments at the time, and it was not until the Fed’s announcement of unlimited quantitative easing some weeks later that European HY spreads finally bottomed. Nevertheless, the rescue plans put in place by European governments, in conjunction with emergency ECB policy, have prevented a tide of bankruptcies from engulfing the European continent. 

The ECB has unleashed its buying power to repress credit spreads in high-grade companies, while higher-risk borrowers have benefited from direct and indirect government lending programmes to keep them liquid during the recessionary period. Emboldened by these unprecedented levels of support, private and public markets have become more comfortable extending financing to many companies that earlier in the year looked as if they might perish.

A high-quality cohort 

A major factor keeping defaults low in Europe is the strong fundamental quality of its companies. For many years the structure of the European HY market has been BB-heavy, with fewer lower-rated companies and fewer default-prone sectors. The region also has lower exposure to Covid-challenged sectors like energy, retail and travel than other global regions, while it has a greater weighting to banks (which have increasingly been protected by authorities due to their systemic importance) and telecoms (which is typically a source of more stable cashflows).

A risk averse crowd

One of the silver linings for creditors in Europe has been that the region’s sluggish growth in the past decade has led to credit-friendly outcomes for investors. Firstly, issuers and their shareholders have lacked the animal spirits that can push managements to excesses in times of strong growth. Appetite for releveraging, mergers and acquisitions and aggressive expansion, while it leads to stronger growth dynamics, can also sow the seeds of credit distress further down the line. 

This defensiveness has also extended to Europe’s capital markets, which have been loath to finance higher-risk deals, meaning that the market has self-selected a lower default rate by not embracing riskier borrowers. Default is also less culturally acceptable in the region than it is in some other parts of the world. European restructuring processes are more complicated and less accepted than Chapter 11 in the US, and European management teams are much more averse to being associated with companies that have gone through bankruptcy.

Benevolence from lenders and shareholders

Improving market liquidity and macro data have obviously played a part in encouraging lenders to finance already highly leveraged issuers. The widespread contribution of equity capital from both public and private shareholders has been a significant support too. But refinancing in difficult times can also be a negotiation between a company and its existing borrowers. In some cases we have seen refinancing from troubled companies this year where it has been in the interests of both borrowers and lenders to kick the can down the road. While future solvency is not taken for granted, in 2020 lenders have been more ready to extend borrowers’ lifelines to buy time for the economic skies to clear, rather than seek more aggressive solutions such as debt-for-equity swaps.

Will there be a default payback in 2021?

One of the frequent questions investors ask regarding the surprisingly low European default rate in 2020 is: has the default cycle just been pushed into the future? We think not, as some of the low-default drivers are structural. Governments and policy makers, fearful of confidence ebbing and unemployment rising, will continue to provide support to struggling sectors and economies. 

European HY companies by and large are already in good shape in this crisis, with high average credit ratings, low expenditure on interest bills, and solid levels of liquidity. Management appetite to dial up leverage or expansion activity will remain low, keeping balance sheet aggression in check. And both public and private markets will continue to extend financing, encouraged by the light at the end of the Covid tunnel, as well as by easy financial conditions. 

Overall, investors should take heart; in the fastest and deepest economic contraction Europe has ever seen, defaults stayed encouragingly low. We think they will stay low in the foreseeable future too.

James Durance

James Durance

Portfolio Manager

Andrei Gorodilov

Andrei Gorodilov

Portfolio Manager