Capital vs Inefficiencies
In the era of plentiful and cheap capital that defined much of the post-GFC period prior to 2022, many European corporates overextended their borrowing capacities and, thanks to ultra-low funding costs, required little earnings growth to cover their interest expense. These dynamics, combined with a weak economic backdrop, have resulted in bloated capital structures now straining under elevated financing costs. These have included large, high-profile, and heavily indebted structures; over the past three years we have seen four of the five largest defaults ever in the European high-yield (“€-HY”) market.
Unlike prior cycles, however, this one has proven to be persistent. In recent months, dispersion has risen significantly, and index-level spreads are a poor representation of the true level of credit risk in European leveraged finance markets. On the one hand, a large part of the market has remained well anchored by ferociously strong demand: record CLO creation, inflows from fixed-maturity funds, and large, long-term income streams into private credit managers from insurance tie-ups. On the other hand, though, the level of distressed credit has risen, in some cases for idiosyncratic and sectoral reasons, but in many cases due to refinancing worries related to over-levered capital structures. This is especially concerning for structures underwritten during the COVID era, which now approach a crucial maturity wall with often loose documentation.
By: Craig Nicol and Oleg Melentyev
Capital vs Inefficiencies
In the era of plentiful and cheap capital that defined much of the post-GFC period prior to 2022, many European corporates overextended their borrowing capacities and, thanks to ultra-low funding costs, required little earnings growth to cover their interest expense. These dynamics, combined with a weak economic backdrop, have resulted in bloated capital structures now straining under elevated financing costs. These have included large, high-profile, and heavily indebted structures; over the past three years we have seen four of the five largest defaults ever in the European high-yield (“€-HY”) market.
Unlike prior cycles, however, this one has proven to be persistent. In recent months, dispersion has risen significantly, and index-level spreads are a poor representation of the true level of credit risk in European leveraged finance markets. On the one hand, a large part of the market has remained well anchored by ferociously strong demand: record CLO creation, inflows from fixed-maturity funds, and large, long-term income streams into private credit managers from insurance tie-ups. On the other hand, though, the level of distressed credit has risen, in some cases for idiosyncratic and sectoral reasons, but in many cases due to refinancing worries related to over-levered capital structures. This is especially concerning for structures underwritten during the COVID era, which now approach a crucial maturity wall with often loose documentation.
