OREANDA-NEWS. Fitch Ratings says in a new report that the outlook for European high yield (EHY) bonds and loans may be impacted by the re-emergence of 2007-style trade and capital imbalances between continental Europe and its trading partners. The conditions for continuation in low default rates and healthy new issuance of EUR75bn each in the maturing EHY bond market and recovering leveraged loan market remain anchored by policy support, refinancing activity and demand for M&A financing. Fundamental credit profiles also appear healthy, despite weak growth, given long-term maturity profiles and strong debt service and enterprise value cover implied by equity markets.

However, the agency notes that there are increasing upside and downside risks to the 2015 outlook. Separate trends appear more pronounced for US, UK and continental European high yield bond markets as the impact from commodity price declines and divergence in currency and interest rate expectations consolidate. Rising macro imbalances, in the form of widening current- and capital-account gaps between continental Europe and its trading partners, may be exacerbated by recent monetary policy actions and related currency movements.

These external imbalances translate into developing internal imbalances with diverging outlooks for producer and consumer sectors in the respective economies. Growing imbalances also imply that the surplus capital accounts in the northern eurozone, once offset by peripheral eurozone borrowing, can find accommodating and sustainable external borrowers particularly in the US and UK trade and capital importing economies.

The upside for EHY rests on more accelerated recovery in headline GDP. For continental Europe, stronger growth may result from less aggressive fiscal consolidation and realisation of productivity gains from de-regulatory structural and labour market reforms. Together with lower-energy prices and currency-aided exports, these policy measures may combine with long-standing corporate restructuring efforts and lead to stronger top-line revenue, margin and deleveraging performance across sectors. Many fallen angels from post-2009 could become rising stars and return to investment-grade.

The downside could result from the combination of already high capital surpluses together with aggressive continental European and even Asian monetary stimulus driving the "search for yield" towards more marginal borrowers on more aggressive terms and conditions. The return of 2007 style "originate-to-distribute" and "covenant-lite" structures on up to 7x debt-to-EBITDA in the loan market, as well as a rise in dividend recapitalisations and deeply subordinated payment-in-kind note issuance in the high yield bond market highlights the impact of excess liquidity.

If US and UK manufacturers become less competitive given stronger currencies and higher wage pressures from recovering unemployment, the sources for growth increasingly fall on credit-driven and potentially unproductive fixed-asset investment and consumption sectors. So long as wage increases keep pace with productivity and borrowing capacity, then US and UK high yield credit spreads will reflect improving profitability and tighten to offset the duration risk from any rise benchmark rates.

If broad debt service capacity across these sectors can at least keep pace with the commensurate rise in debt, then the benign narrative of European export growth and rising productivity will continue, even if it remains unbalanced through 2015. The key will be whether increased productivity gains in the eurozone leads towards lower unemployment and a potentially stronger currency combine to eventually offer new sources of demand that allow the current imbalances to reverse without any 2007 style disruption.