PGIM Fixed Income - Wed, 10/26/2022 - 19:54

European High Yield in the Era of Inflation

  • In our third post on the opportunities in European high yield, we place this year’s jump in yields in the context of our expectations for inflation to peak soon and decline thereafter.
  • Therefore, while yields are currently lower than inflation, we expect this relationship to reverse in 2023.
  • In this scenario, actively selecting sectors and issuers with the ability to withstand inflation can provide compelling inflation-adjusted returns over a prolonged investment horizon.

Inflation is peaking as GDP growth slows

When looking at inflation globally, the main, regional drivers can add perspective to allocation considerations. In Europe, prices are rising mainly because of energy costs and not, as in the U.S., because the economy is overheating amidst elevated shelter and wage costs. For example: negotiated wage growth in the Eurozone is set to remain below 3%, which is consistent with the European Central Bank’s (ECB) 2% inflation target and well short of 6%+ expected wage rises in the U.S.

Therefore, when looking at the totality of the inflation picture, we project that Eurozone inflation will decline from 8.4% in 2022 to 2.8% in 2023 as growth contracts (Figure 1). For the UK economy, we project 13.1% inflation this year that will fall to 5.5% in 2023.

On economic growth, we expect Eurozone GDP to grow 3.2% this year, but to shrink 1.4% in 2023. The sudden halt in Russian energy supplies remains a crucial risk to Europe’s economy. If gas supplies remain suspended, growth in Europe might be impacted for several quarters.

Figure 1: Europe’s energy-driven inflation is set to peak alongside GDP growth

Source: PGIM Fixed Income, Macrobond, as of September 2022.

High-yield bonds can provide healthy inflation-adjusted returns

The European high-yield bond index yielded around 3% at the start of 2022 and more than 8% at the end of September. If our inflation estimate for 2023 is correct, that would provide 5.8 percentage points in excess yield (Figure 2). Locking in these recent yields, or higher in the next few months, can provide attractive inflation-adjusted returns for years to come.

Figure 2: European Bond yields versus inflation

Source: PGIM Fixed Income, as of 30 September 2022.

In addition, with inflation set to fall in 2023, if ECB policy rates peak at the end of this year (which would be sooner than current market expectations) that pivot could provide additional upside to the prices on European high yield bonds.

Issuer selection within high-yield portfolios can also help protect against inflation

As our research analysts and portfolio managers seek an optimal portfolio allocation, they select about one quarter of issuers from the investible high-yield universe. That industry and issuer selection, which has occurred throughout market cycles and varying investment conditions, has historically helped us outperform our benchmarks along the way. In the current environment, selecting companies that are better able to manage inflation is a point of emphasis.

For example, we favour sectors with longer-term sustainable pricing power, such as telecom and cable firms, because their prices often adjust with inflation. At the same time, we look beyond short-term trends: travel and leisure firms, for example, had some pricing power after two years of lockdowns, but is that pricing power amongst consumer discretionary issuers sustainable heading into a recession?

Energy-intensive and high-labour cost sectors, by contrast, will find it difficult to pass on energy and wage inflation. This warrants caution about earnings prospects over the near to medium term. Finally, rate-sensitive sectors, such as real estate, have come under pressure as interest rates on government bonds have risen.


Yields on European high-yield bonds have more than doubled in 2022, but they remain lower than recent inflation readings. However, we expect inflation to peak soon and decline thereafter, so locking in yields sooner rather than later can provide attractive inflation-adjusted returns over the longer term. That makes high-yield bonds a valuable addition to any portfolio.

Furthermore, corporate balance sheets across Europe are in good health as we enter a potential downturn, and the default outlook remains benign compared to previous downturns. That should allow investors to generate high risk-adjusted returns over the medium to long term.

Read More from PGIM Fixed Income

Source(s) of data (unless otherwise noted): PGIM Fixed Income as of 24 October 2022.

PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. Clients seeking information regarding their particular investment needs should contact their financial professional. These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.

In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2022 PFI and its related entities.


Sign Up Now for Full Access to Articles and Podcasts!

Unlock full access to our vast content library by registering as an institutional investor .

Create an account

Already have an account ? Sign in