LONDON, Feb 27 (Reuters) - European high yield corporate debt is increasingly vulnerable as the global economy slows, suggesting a higher risk of defaults, Deutshe Bank said in a note on Monday.
While the sector spans issuers rated BB+/BA1 and below, those with a single-B rating or lower now make up 38% of Deutsche's high-yield bond index, the highest in a decade after a wave of real estate downgrades.
However, that compares favourably to the United States, where equivalent credit accounts for 51% of a similar index.
Sentiment in Europe has received a boost from the recent sharp fall in energy prices and China's economy reopening but several headwinds remain, including the lagged impact of European Central Bank rate hikes and the risk of a U.S. recession dragging on European corporates, Deutsche noted.
The ECB has raised interest rates by a total of 300 basis points since July to 2.5%.
Deutsche, which warned in January that a credit rally would likely end soon, said European earnings had already slowed in the last quarter of 2022 and expectations for 2023 were down 7% versus earlier forecasts.
Sales of new high yield bonds got off to a promising start in January, but slowed in February as volatility in interest rate markets weighed, the note said.
Nearly 60% of new high yield bond sales came from financials, corporate hybrids - a type of security that has bond and equity features - or fallen angels recently downgraded from investment grade to junk. "Genuine" issuance of lower rated credit was just over 6 billion euros ($6.34 billion).
Deutsche said it expected around 55 billion euros in high yield bond supply in 2023, 15 billion euros more than in 2022, and anticipated a marginal increase in merger and acquisition and leveraged buyout activity in the first half of the year.
It added that higher financing costs and an uncertain economic outlook should push firms to try to reduce leverage, while refinancing needs for the year were limited but expected to gradually increase from next year.
The bank said it sees a better risk/reward play in investment grade credit, such as tier two bank debt and hybrids, particularly if the market sells off.
