Distressed bonds skew high yield market averages
The European high yield market presents a deceptive picture of value. While the headline spread suggests generous compensation for taking credit risk, the figure is heavily distorted by a small number of distressed bonds.
Splitting the CCC bucket
The CCC & Lower Euro High Yield Index currently sits at 1,306 basis points over government bonds. This number creates an illusion of safety, but it mixes two very different groups of companies. The market contains performing issuers that continue to meet obligations and distressed issuers that are trading on expected recovery values. Combining these two produces an index spread that describes neither group accurately.
Performing CCC bonds, which trade below 1,000 bps, offer a spread of 438 bps. This figure is tight by historical standards and much closer to the spreads available on higher-rated single-B bonds than the headline number implies. These are companies the market broadly expects to service their debt, yet investors are not being paid nearly 1,306 bps to accept the meaningful default and liquidity risk involved.
For bonds trading above 1,000 bps, the analysis shifts entirely. The outcome and timing of a potential restructuring dominate the price, making spread a poor guide. The aggregate index spread therefore conflates conventional spread assets with potential recovery assets, failing to provide a reliable measure of compensation for performing credit risk.
The median effect
The distortion extends beyond the CCC segment. These accounts make up only 4.3% of the European high yield index. If the distortion were confined to this small part of the market, it would be of limited relevance. However, a relatively small number of distressed bonds can have a disproportionate effect on the average spread of the entire market.
Distressed bonds exhibit extremely high spreads, even when this metric is no longer the best way to evaluate them. The presence of these bonds skews the average spread upwards, making it higher than what is available for most performing bonds. This discrepancy is evident in the difference between the mean and median spreads. While the mean is sensitive to the extreme values of distressed bonds, the median remains unaffected, providing a more accurate representation of the middle bond’s spread in the distribution.
The median spread, currently at 169 bps, offers a more subtle view of the market, indicating that the typical performing bond is priced more aggressively than the headline mean index spread of 244 bps suggests. This disparity in perspectives tells two different stories about the European high yield market. The median spread, which is close to the lower end of its range over the last five years, provides a more realistic picture of the market’s value proposition.
