Bond Voyage

Read this article to understand:

• Why credit selection in high yield will become even more critical in 2024
• Why this time really is different for UK gilts
• Whether income will be king next year
• How heeding the lessons of Christmases past could help EMD investors

A warm welcome to Bond Voyage, our fixed-income blog series where we – an assorted crew of hardy veterans and more youthful members of our fixed-income teams – put a spotlight on the stories that have sparked debate on the desks. Our commitment is simple: unfiltered thoughts, no fund mentions, no hard sell and certainly no goodbye bonds.

Feedback is important to us, so please send any thoughts on what you like, don’t like and suggestions on what we might cover in future blogs to: gcs.creditinvestmentspecialists@avivainvestors.com

High yield: Credit selection isn’t just for Christmas

There is a lot to feel festive about in the high-yield market: yields are at attractive levels, corporate fundamentals remain robust and technicals are strong (as we highlighted last month).¹ But as we head into 2024, some in the market are fearful over maturity walls (where a large share of bond issues matures, and issuers have to issue new debt at prevailing rates).

In our view, you might do better in worrying about decking the halls. Equally, we understand with an uncertain macroeconomic picture, higher-for-longer rates and fears of increasing defaults, investors remain cautious. If you just focus on the cost of capital, these worries are fair; the average coupon sits below six per cent today, while the prevailing yield is closer to nine per cent. That is quite a gap to bridge.

However, our analysis points to a more positive story. Less than two per cent of the index (Bloomberg Global High Yield xEM xCMBS 2% issuer capped, USD Hedged) is maturing at the end of 2024, and while a lot of this is CCC-rated debt – the most vulnerable bonds to an economic downturn – we still anticipate the 12-month default rate to hover around the long-term average of between four and five per cent. Most of the debt coming to market over the next two years is on Santa’s good list; higher quality BB-rated names not only have healthier fundamentals, but also benefit from lower borrowing costs. Furthermore, most debt will mature in 2027 and 2028.

It is unlikely to be such a happy CCC-Christmas for lower-rated credits, however. The average current coupon among CCC issuers is around seven per cent, less than half of the market rate of around 15 per cent. Such a high cost of capital will be unsustainable or unpalatable for many issuers, which seems likely to result in many lower-quality names defaulting. Even for those that can refinance, their interest burden will increase substantially.

The key message for investors is that credit selection isn’t just for Christmas; it will be even more critical in 2024.

Global sovereigns: Gilt supply is coming to town…

Christmas has come early if your wish was for even more gilt supply over the next few years. UK Chancellor Jeremy Hunt presented an Autumn Statement aiming to kick-start growth by announcing a two per cent cut to the main National Insurance contribution.

The statement is a reminder that governments face a difficult path of trying to reduce fiscal deficits enough to calm markets, but at the same time support growth. Although memories of September 2022’s mini budget remain fresh, we believe “this time is different”.

For starters, the gilt market is in a much better place. UK inflation has halved, and bank rates are now 3.5 per cent higher than they were in September 2022. Whilst supply will remain elevated for the foreseeable future, we expect inflation will continue to fall and interest rates will also begin to move lower. This environment will see a more balanced and stable market heading into 2024, which, as bond investors, is high up on our Christmas wish list.

Investment grade: Income all ye faithful

Most bond investors have not felt joyful and triumphant over the past 12 months or so. Macro headwinds and geopolitical risk, combined with the mini-banking shock in March, has left many feeling bruised and hoping for relief in 2024. But while cash might have been king in 2023, we think income will take its place in 2024.

Even the least exciting of mixed-asset fixed-income funds are yielding north of eight per cent. Locking in that level of income for investment-grade assets could certainly be a stocking filler, or as those in the markets might say, “I’ll have a TIARA for Christmas this year please”. For yes, there is a real alternative to equities, with cash, short-dated Treasuries and US investment-grade bonds all offering more than the S&P 500 on an all-in yield basis.

Many forget bonds don’t require growth to continue to deliver income, something that can get lost in the macro narrative of the moment. Yes, credit spreads have ground tighter across the board, particularly in recent weeks as the US market grapples with the narrative of “what next?” and “could there really be a soft landing?”. But at the start of December, the broad US investment-grade market still had an option-adjusted spread of 114 basis points, a level not seen since February 2022, just before Russia’s invasion of Ukraine.

While companies face increased financing costs, fundamentals are still in reasonable shape. With most investment-grade companies issuing long-dated bonds at cheap costs in 2020, we are less concerned about a maturity wall than parts of the market further down the credit spectrum.

The challenge will still be cash rates through the first half of 2024. Some investors may question the benefit of investing in a spread product for the same yield as they can get on cash. It’s a valid question. But readers should note that while interest rates will likely be higher for longer, they will not be higher forever. As such, investors might well consider locking in the elevated income on investment grade now.  

Emerging markets: Last Christmas

Nostalgia comes with the territory at this time of the year, with the airwaves filled with festive songs of yesteryear. So, as we on the emerging-market desk ponder the key lessons we have learned over the years, and where we see future opportunities, what better song to soundtrack our thoughts than Wham!’s mournful classic, Last Christmas?

Investing successfully in emerging-market debt takes tenacity and remaining true to your philosophy, seeing opportunities where others see risks, and risks where the market sees only opportunities.

The first lesson is that institutions, and their impact on politics and policymaking, matter more than economic growth or any other macroeconomic variable. Countries with strong institutions are best placed to deal with shocks, which are a regular occurrence in emerging markets. 

The second lesson is that it is not unusual in emerging markets for investors to sell first and ask questions later, or for exchange-traded funds to be indiscriminate sellers (or buyers). Investors should see knee-jerk reactions as an opportunity.  There are more than 60 countries in the hard-currency universe, along with select opportunities in the local-currency, quasi-sovereign and corporate parts of the market. Countries can be at different points in their credit-quality cycle, have different response functions and may benefit in ways that may not be immediately apparent.

Thirdly, while history matters – because countries that default once are more likely to do so again – investors should keep an open mind because situations change.

Fourthly, and related to the third point, investors should be flexible and not afraid of changing their view as situations evolve. Keep focusing on identifying and assessing risks and opportunities, but once these have materialised, be prepared to re-assess. Today’s risky country could well become tomorrow’s opportunity.

Finally, address any biases. Simply because a country has a high credit rating and is perceived as being low risk, that does not mean it has a favourable risk profile. Price matters.

So, what about 2024 and beyond? In our view, higher-for-longer US rates make bottom-up analysis even more critical. With real rates rising in developed countries, emerging-market nations face being crowded out in the competition for capital.

Those with sound fiscal metrics and macroeconomic policies should be best placed to avoid this. And, as the first phase of monetary tightening draws to a close, fiscal policies will become important to monitor. Countries that can strike a balance between supporting growth without fuelling inflation and worsening fiscal metrics should be more attractive.

As for high-yield issuers, avoiding default may come down to their access to multilateral finance, willingness to engage with the International Monetary Fund and whether they have rich friends or opportunities to privatise businesses. That said, while defaults are attention grabbing, this risk is priced into most countries’ debt.

Our attention is instead focused mainly on countries at risk of having to pay materially more to issue, and where yields could rise substantially. Take Mexico. The country is injecting billions of pesos into Pemex to keep the world’s most indebted oil company afloat. Pemex owes creditors more than $100 billion, equivalent to eight per cent of Mexico’s GDP.

In our view, the best way to deliver consistent returns is to split the universe into three buckets. While spreads do not look especially compelling, nominal yields are far from unattractive relative to history, particularly in higher-rated market segments. In the middle bucket are high-yield names with strong fundamentals that still offer a decent pick-up relative to Treasuries and scope for further spread compression.

At the other end of the spectrum, distressed and defaulted debt also offer value on a selective basis. While investors may need a resumption of inflows and stability in core rates to see significant upside potential, countries like Egypt, which we expect to muddle through, and Ecuador, which has been overly penalised for political risk, could provide opportunities over the medium term.