The U.S. high yield market has long been regarded as the global benchmark: deeper, more liquid, and broader in sector composition. For many allocators, U.S. high yield has traditionally been the default source of carry. However, the relative case is becoming more nuanced. In an environment where currency dynamics, political risk and downside mitigation matter as much as headline spreads, European high yield is increasingly viewed not merely as a complement to U.S. exposure, but as a strategic allocation in its own right.

“The European high yield bond market is big enough to allow, in particular European investors, to diversify away from the U.S. and the U.S. dollar,” says Charles Watford, lead portfolio manager of PIMCO’s European High Yield strategy. On a currency-hedged basis, Watford sees little difference in absolute yield between the two markets. “If you look at euro-hedged yields, they’re broadly identical. U.S. high yield hedged back into euros is around 4.5 to 4.8 percent^[1], depending on the day. European high yield is in a very similar range,” he explains.

“If you look at euro-hedged yields, they’re broadly identical. U.S. high yield hedged back into euros is around 4.5 to 4.8 percent, depending on the day. European high yield is in a very similar range.”

While some allocators remain hesitant to scale back U.S. equity exposure, the calculus in fixed income is fundamentally different. “When you come to fixed income, it’s more about downside mitigation,” Watford emphasizes. “It’s about capturing that carry and seeking to avoid the downside.” In that context, he argues, the relative case for Europe strengthens. “This is a higher-quality market offering the same potential yield on a hedged basis with sufficient diversification,” he says. “If you’re a European investor, why would you necessarily want the additional U.S. political and currency exposure, when you can achieve similar returns domestically?”

Quality Advantage and Market Depth

The European high yield market has grown to roughly €400 billion in outstanding issuance, spanning around 400 issuers^[2]. That represents approximately one quarter of the global high-yield market by size. According to Watford, this scale is sufficient to construct diversified portfolios across sectors, ratings buckets and maturities. “It’s large enough to build a genuinely diversified portfolio across different sectors and companies. You’re not constrained in terms of breadth,” he says.

More importantly, the European market screens better on average credit quality. “Only about 7 percent of the European high-yield index is triple-C rated, compared to roughly 11 percent in the U.S.,” Watford notes. “Historically, European high yield has had average default rates about one percentage point lower than the U.S. market.”^[3] That structural difference matters, particularly in late-cycle conditions. “Over time, lower default rates should translate into outperformance, all else equal. And in a recessionary scenario, you would expect European high yield to hold up relatively better,” he argues.

Fundamentals Supportive, Spreads Tight

Watford breaks down the investment case across three dimensions: fundamentals, yields and spreads. On fundamentals, he sees resilience. “Leverage in European high yield is at the lowest levels we’ve seen in five to ten years,” he says. “The higher-rate environment has forced companies to be more disciplined in terms of borrowing.” He does not observe signs of excessive risk-taking or late-cycle overconfidence. Typically, such behavior would manifest in surging issuance volumes, elevated M&A activity, or aggressive capital expenditure plans. The more subdued level of public market issuance, he adds, may in part reflect the rapid growth of the private credit and broadly syndicated loan markets, which have absorbed a meaningful share of financing activity.

Yields remain attractive in absolute terms, largely because of the higher starting point in risk-free rates. Duration in the European high-yield index remains relatively short, typically between 2.5 and 3 years, limiting sensitivity to interest rate movements. Spreads, however, are undeniably tight. “Across credit markets, investment grade and high yield, both in the U.S. and Europe, spreads are in the tightest quartile of the last decade,” Watford observes.

“In a downturn, you could see 150 to 200 basis points of spread widening. But with two and a half to three years of duration, that kind of widening would likely leave you with roughly flat total returns over a 12-month horizon rather than with deep losses.”

Still, he believes fundamentals provide some justification for current levels. “There is support for these spreads from fundamentals.” The main risk remains a recessionary shock. “In a downturn, you could see 150 to 200 basis points of spread widening,” he says. “But with two and a half to three years of duration, that kind of widening would likely leave you with roughly flat total returns over a 12-month horizon rather than with deep losses.” In that sense, carry may provide a meaningful cushion.

Dispersion and the Case for Active Management

While average spreads are tight, dispersion within the market has increased, creating opportunities for active managers. “There’s a meaningful portion of the market trading at 150 to 200 basis points, but there’s also a sizable segment trading at 400 to 1,000 basis points,” Watford explains. “In euros, that’s roughly 7 to 12 percent yields.”

Default avoidance, he emphasizes, is central to generating excess returns in high yield. “If you’re getting 5 percent carry on average, you need a lot of winners to offset one default. Default avoidance is one of the largest sources of excess return potential.” He frames it quantitatively: “If defaults run at 2 to 3 percent and we can avoid half of them, that alone could translate into 50 to 100 basis points of outperformance versus the index.”

“If defaults run at 2 to 3 percent and we can avoid half of them, that alone could translate into 50 to 100 basis points of outperformance versus the index.”

Active managers can also add value through new issue premiums, covenant analysis and capital structure positioning. “There’s usually a new issue premium,” Watford notes, adding that rigorous analysis of covenants and security packages can also position managers in more attractive parts of the capital structure. In addition, index-related inefficiencies create opportunities around rating migrations. “When bonds move from investment grade into high yield or vice versa, there’s often the ability to capture better risk-adjusted returns,” he explains, referring to forced buying and selling dynamics among benchmark-constrained investors. 

“When bonds move from investment grade into high yield or vice versa, there’s often the ability to capture better risk-adjusted returns.”

Beyond the benchmark universe, Europe also offers select off-index opportunities. Some issuers remain unrated and therefore excluded from major indices, yet may present compelling fundamentals and attractive compensation for risk. For active managers with the resources to conduct bottom-up credit work, these segments can represent a differentiated source of outperformance.

Portfolio Construction and the Role in Asset Allocation

Backed by a global team of more than 80 credit analysts, almost 20 of whom are based in Europe, the PIMCO European High Yield strategy is structured around three alpha levers: structural, thematic and opportunistic. “The structural bucket focuses on areas with historically better Sharpe ratios, such as the front end of the curve, rising stars and fallen angels,”^[4] Watford explains. Thematic positioning reflects broader macro and sector developments. “In an environment of rate cuts and improving credit quality, sectors like real estate and financials can benefit. Artificial intelligence is another theme, supportive for utilities, potentially more challenging for certain software names.”

Lastly, the opportunistic allocation seeks to exploit market dispersion. “We look at segments trading at 6 to 12 percent yields and ask whether we are being compensated for the risk,” says Watford. The emphasis is not on stretching for yield, but on identifying situations where spreads imply a more negative outcome than fundamentals suggest. As bond investors with a strong focus on default avoidance, diversification and risk control remain central to portfolio construction. The strategy typically holds between 150 and 250 names, with position sizing driven by conviction, liquidity and downside risk. “Higher-quality, more liquid positions might be 75 to 100 basis points overweight compared to the benchmark, while more event-driven names might be closer to 25 basis points,” he says.

“Historically, high yield has offered comparable returns to equities with roughly two-thirds of the volatility. For an allocator, having part of your European equity exposure expressed through European high yield can make sense.”

From a broader asset allocation perspective, Watford argues that European high yield offers three clear potential benefits: attractive carry with limited duration risk, reduced exposure to U.S. political and currency dynamics, and historically equity-like returns with lower volatility^[5]. “Historically, high yield has offered comparable returns to equities with roughly two-thirds of the volatility,” he notes. “For an allocator, having part of your European equity exposure expressed through European high yield can make sense.”

The PIMCO European High Yield strategy has pursued strong performance across different market environments both on an absolute and risk-adjusted basis. According to Watford, this has been driven primarily by disciplined credit selection and a strong emphasis on downside mitigation. “It’s been achieved by credit selection, including avoidance of some of the weaker names and a significant focus on risk management.”