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Major forces are bearing down on Europe right now; some structural and some fleeting. In an environment where a Trump tweet can turn markets, it is hard to predict market sentiment and make relative value judgements between the US and Europe from day to day.

Instead, we focus on more structural market dynamics. These include the continued disintermediation (or maturation of Europe’s corporate lending ecosystem), the strong fundamentals and low default rates of high yield, syndicated loans and direct lending, as well as the potential impact of a savings and investments union (SIU) should one come to fruition.

European companies source a much higher proportion of funding from banks than their US counterparts. Estimates vary, but most place European bank funding at 85% vs. 50%-55% for the US.

Should Europe’s capital markets mature, and align more closely with the US mix of corporate funding sources as experts typically expect, then a structural opportunity in non-bank lending will likely open up. Stricter capital requirements on banks (e.g., Basel III/IV) will likely be a key factor in driving this trend.

Figure 1: Corporate lending at EU banks has declined by 15-20% vs. 2007 – 85% of corporate debt financing in Europe is provided by banks

USD: Size of main debt financing sources in Euro

Sources: LCD, EBA, FDIC, FRED St. Louis, EBF, BIS, Hayfin internal analysis, �۶���Ƶ Asset Management. Data as of May 2024.
1 Non-financial corporate debt (i.e. excluding financing between bank) and including CRE loans; European banks loans only (excluding the UK banks)
2 Including the UK markets

Figure 2: US banks have increased corporate lending by 1.8x vs. 2007 but bank financing represents only 50-55% of total debt financing sources

USD: Size of main debt financing sources in US

Source: LCD, EBA, FDIC, FRED St. Louis, EBF, BIS, Hayfin internal analysis, �۶���Ƶ Asset Management. Data as of May 2024.
1 Non-financial corporate debt (i.e. excluding financing between bank) and including CRE loans; European banks loans only (excluding the UK banks)
2 Including the UK markets

Outside of traditional bank loans, the European corporate debt market is made up of a large liquid investment-grade bond market and a sub-investment-grade market that is broader than ever (public high yield, syndicated loans, and direct lending). Although these are distinct markets, companies can effectively engage with all three to achieve the best cost of capital outcome and to align with investor preferences.

The markets have also been intermingling, offering more avenues and flexibility for companies to access capital.

From a demand perspective, insurers, pension funds, and private debt funds are increasingly targeting corporate credit for higher returns in a low-rate environment (even as rates rise, spreads remain attractive). Many investors are also structurally underweight Europe in global high yield portfolios. In our view, it is reasonable to expect this to right-size over time and allocations to rise accordingly.

Credit selection and risk management will become increasingly critical as the cycle matures.

All corporate debt markets are benefitting from tariff de-escalation policies which are helping spreads retrace lower and returns move further upwards. And, despite recent broad volatility, we believe credit is in a good place – especially in Europe. But there are some tail risks.

Companies are finding it easier to access primary market financing,

and investors are feeling more confident in appraising companies' prospects as the year progresses. Predicting short-term market moves is a fools game. Instead, it pays to try and look through the noise and focus on the underlying fundamentals of the market and issuers.

In terms of high yield, Europe is arguably the highest quality market, with 70% of the market rated BB. A large proportion of this is publicly listed, benefiting from the higher transparency that comes with it. This usually results in low default rates when compared to private credit markets, which may be used to finance more private equity transactions.

Currently, valuations in the European high-yield market are at fair value with spreads of approximately 350-400 bps, around the long-term average, and yields at 5.75%-6.25%, above the long-term average. The tariff-driven economic slowdown is not translating into higher default risk, just a slower pace of deleveraging which can reverse quickly.

Syndicated loans are typically used to finance private equity buy-outs, with the majority of the market being B-rated. Loan markets have delivered strong returns over the last few years and loan investors benefit from the low volatility of the asset class owing to three primary protective mechanisms: i) senior secured product, low default rates and high recoveries, ii) floating rate product with no meaningful duration and iii) an investor base dominated by CLOs, semi-permanent capital structures that are rarely forced sellers. With loan spreads currently around 400 bps, we believe they are attractively priced for investors.

Looking at loans globally, European loans (hedged to USD) have generated significant excess returns over US loans over a prolonged period of time, primarily due to lower cumulative default rates, strengthening the argument for a global loan allocation.

Direct lending markets have benefited from significant investor demand in recent years as marketed excess spread of approx. 200-400 bps over liquid loans in a longer-term private equity-style fund format has drawn interest from a wide range of investors looking to diversify credit exposure into floating rate product.

The post Ukraine invasion vintages of 2022 and 2023 are generating strong returns as private credit lenders made capital available in a period where capital was scarce and expensive (bank balance sheet overhang, junior capital solutions, private amend and extend of challenged public loan/bond transactions). The spread compression since 2023 has generated excess returns for private credit investors, but has also caused the opportunity set today to be far less compelling as the spread premium compared to public markets has eroded materially.

Taking a step back from the current market dynamics, it is also important to consider some fundamental policy changes that could be on the horizon. Former Italian Prime Minister Enrico Letta’s single market framework is based on the free movement of knowledge, data, and innovation. For companies and institutions seeking debt capital, Letta’s philosophy promotes a more dynamic European capital market, aiming to direct Europe's vast private savings into productive investments like digital and green infrastructure and other corporate funding.

Letta calls for “EU-wide harmonization of insolvency regimes” and “tax treatment of debt vs. equity” to reduce geographical fragmentation. This could lower cross-border risk premiums and reduce borrowing costs for corporates, especially in high yield and private credit. More efficient restructuring under the proposals would likely boost recovery rates for distressed debt investors.

Liquidity, particularly in syndicated loans and private credit, could be greatly increased under a “unified European securitization market” and support for “SME bond listings” as non-bank lenders (e.g., private credit funds) could securitize loans more easily, freeing up capital for new lending. By removing barriers for insurers/pension funds to invest in private debt and securitized products more institutional capital is likely to flow into private credit, particularly direct lending and infrastructure debt. And a more unified market should also reduce an element of home bias that exists across investor portfolios.

Meanwhile, consolidated supervision (e.g., European Security and Markets Authority) is designed to standardize covenants and disclosures and could significantly improve transparency.

From a sector specific perspective, great financial union would improve access to bond markets and private credit for mid-market and small-to-medium enterprises. Easier securitization and institutional investment could lower financing costs for infrastructure and green projects. Lastly, more efficient insolvency rules would likely attract special situations funds in high yield and distressed debt.

Ultimately, greater financial union should improve financing depth

as it would remove multiple barriers that prevent freedom of financial conditions, such as: different regulations; different legal documentation; differing settlement cycles; and different investment rules. In theory, this could mean there would be larger deals with more investors taking part. Spreads would therefore, benefit through larger order books – i.e., prices go lower, much like an IPO. But the implications may not be identifiable until years down the line.

First and foremost, spreads will be driven by risk appetite. And, as Yogi Berra dearly reminds us,

It's tough to make predictions, especially about the future.

However, with seismic proposals on the European policymaking table, and a political climate ripe for once-in-a-generation breakthroughs, any prudent investor must consider the potential outcomes ahead. Regardless of whether we see a greater financial market union, or much greater integration across other markets in Europe, such thought experiments are never wasted.