Bond Voyage

Read this article to understand:

• Improving fiscal discipline in emerging markets
• Processes and outcomes in investment grade
• Divergence between the US and Canada
• Why a focus on developed markets in global high yield makes sense

Welcome to June’s Bond Voyage newsletter. This month, our emerging-market debt (EMD) team reflects on improving discipline among issuers in both sovereign and corporate markets (with a little help from Shania Twain). We use a sporting analogy to illustrate the importance of the right portfolio construction process in investment-grade (IG) credit. Meanwhile, our global sovereign bond team discusses opportunities in Canada, and in global high yield, we explore why a focus on developed-market risk can be beneficial.

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Emerging-market debt: Ka-ching, it’s a beautiful thing

This month the EMD team mulls the topic of fiscal dominance (with a little help from the lyrics of Shania Twain’s 2002 hit “Ka-Ching!”).

What is fiscal dominance? Simply put, it’s when budget deficits and debt become so large that they start to erode the effectiveness of monetary policy. Higher debt levels leave countries and their politicians more vulnerable to shocks, a lesson that many in EM have learned the hard way in recent years.

Indeed, having come close to the brink in the past, many emerging and “frontier” markets have been recently displaying a greater commitment to reform, as we saw on our recent trip to the International Monetary Fund/World Bank Spring Meetings.¹ Argentina, most notably, is finally learning the lesson, with President Milei trying to address previous fiscal policies that contributed to the country’s triple-digit inflation. 

And so we can’t help but notice what would have seemed unimaginable just a few years ago: that while a number of EM countries are returning to a path of fiscal prudence, some DM countries may be moving in the opposite direction. There are growing concerns about the impact of fiscal dominance in the US and its potentially inflationary consequences, for example.

With this in mind, we thought it would be an interesting exercise to run the US through our “vulnerability model”, which measures key credit metrics such as budget deficits, interest costs and external financing requirements, to see how it compares to the EM countries we usually track. (We are, of course, fully aware that the size of the US economy and the role of the dollar as a reserve currency makes it very different from Argentina, Brazil or South Africa.)

So what does our model suggest? If the US were an emerging market, it would be the most vulnerable country in the category (see Figure 1), due to its budget deficit of eight per cent and public debt at over 100 per cent of GDP. But perhaps the most telling metric is interest cost-to-revenue, currently sitting at 9.6 per cent even after a decade of low rates. This is not to say that, as and when growth slows, US Treasury yields won’t come down, nor that we are at risk of rates moving materially higher from here. But we do think it’s increasingly important for investors to think about the US as a “normal” credit, and about what that might mean for US Treasuries over the medium term.  

EM discipline is also evident in the corporate market. While many EM corporates continue to hear that lovely sound, “Ka-Ching”, thanks to robust earnings, the majority are not splashing out on diamond rings or other luxuries. Rather, the focus remains on cost control and maintaining prudent leverage levels.

With the first-quarter earnings reporting period in full swing, we are seeing decent momentum continue, with numbers coming mostly in-line or slightly ahead of expectations. As usual, the broader strength in fundamentals does hide the substantial disparity we are seeing across sectors and geographies, and the team remains highly focused on sector and security selection in the EM corporate space.

Investment-grade credit: Trust the process

We on the IG credit team are excited about a big summer of sport, with the Olympic and Paralympic Games in Paris, football’s European Championships and the Wimbledon tennis tournament all coming up soon. 

This busy calendar got us thinking about the parallels between sport and fund management. One distinction elite athletes often make is between “process” and “outcome”. If a runner focuses solely on the outcome – beating a personal best, say – they may neglect the sorts of processes that can contribute to that goal, such as undertaking a set number of practice sessions per week. 

In investment too, it’s crucial to acknowledge the importance of both processes and outcomes, especially in times when market conditions are challenging. 

One function of the current environment of very tight credit spreads, coupled with all-time attractive yields within the investment-grade universe, is that it has pushed investors to allocate to riskier and riskier areas of the credit market. This concerns us. We do not feel macro risks are sufficiently priced into spreads, even though the structural push towards yield and high-quality fixed income is providing a positive technical support.

There’s a longer-term trend at play, here. During the post-financial crisis years of tight spreads and low dispersion, positioning across the IG market became very reliant on credit beta, rather than credit alpha. As a result, excess returns tended to be strong during bull markets, with managers struggling to deliver positive outcomes during periods of widening spreads. 

We believe we are now facing a period of greater macro uncertainty and volatility in markets, and that therefore a beta-led approach to credit investing is likely to result in larger and more frequent drawdowns in the future.

So, what’s the answer? One way to succeed in this environment is to ensure you have the right investment process in place. For instance, standard sector breakdowns, which allocate securities by industry group, may miss the significance of differences between credits, whether they lie in credit ratings, volatility, maturities or correlations. As an example, just because Microsoft (rated AAA) and Dell (rated BBB) are both in the technology sector, does not mean their bonds share similar risk metrics in the credit markets. 

This is why we prefer to use custom sectors, defined by beta and historic volatility, as part of our portfolio construction approach. This helps us to avoid continually adding more and more high-beta securities to outperform the benchmark, and enables us to focus on targeting the same level of volatility as the benchmark, while staying broadly within the boundaries of IG and aiming to optimise returns. Like any athlete limbering up for a big race, it’s all about trusting in the process as a way to deliver the outcome.

Global sovereigns: O Canada!

Canada is different from the US in many ways. Up north, they prefer ice hockey over baseball, the metric system over imperial units, Keanu Reeves over Tom Cruise. And now the two countries are diverging in another sense.

As we came into 2024, we thought it could be a year when major economies started to follow meaningfully different trajectories. This is starting to happen, and central banks in some countries are now closer to starting their expected cutting cycles.

While sticky underlying inflation is likely to prevent the Federal Reserve and Bank of England from cutting rates (for now, at least), the European Central Bank made a rate cut on June 6 despite improving economic data in the euro zone. Switzerland and Sweden, too, have begun to ease monetary policy.

Similarly, the Bank of Canada (BoC) lowered its policy rate to 4.75 per cent from five per cent on June 5. Unlike the US, Canada has made good progress on inflation reduction this year. Between January and April 2024, Canada’s month-on-month CPI prints averaged 0.1 per cent (in the US, month-on-month personal consumption expenditures inflation averaged 0.3 per cent). The BoC’s preferred measures of underlying inflationary pressure, the median and trimmed means, support the disinflationary story with those measures now falling below three per cent on a year-on-year basis.

We think this makes sense, with the Canadian economy exhibiting more interest-rate sensitivity than in the US. In Canada, households typically fix mortgages for up to five years, rather than the 30 years that is common in the US. In addition, labour-market rebalancing – the unemployment rate has steadily risen from five per cent in early 2023 to 6.1 per cent as of April – gives us confidence that wage growth should continue to decline and, with it, the risk of sticky services inflation. High and rising household debt servicing costs have given the central bank an incentive to act sooner rather than later and mitigate stability risks (see Figure 3).

As a result, we think Canada offers interesting opportunities for investors right now. We have moved overweight short-dated Canadian rates based on our view of the cutting cycle. Ongoing economic strength in the US is a risk to the trade, as the two economies are closely interlinked. But if this occurs, we believe there is enough in the Canada fundamental story to support true divergence between the two economies. Alternatively, US rates could prove to be a tailwind if survey data hinting at a weaker labour market does transmit to the hard data. Moreover, the start of the cutting cycle could encourage more premium to be priced further out the Canada term structure, steepening the yield curve and supporting our existing curve exposure. 

Global high yield: Keeping things separate

Socks and sandals. Pineapple and pizza. Passwords and Post-it notes.

Sometimes it’s best to keep things separate.

On a similar note – and with all due respect to our colleagues on the EM debt team – we believe it makes sense to manage developed-market high yield bonds separately from emerging-market debt at a strategy level.

Although the US dollar-denominated market for debt from EM issuers has grown rapidly in recent years, and is now larger than the US high-yield market, we’ve chosen to exclude EM bonds from our global high-yield strategy. The main reason for this is the different risk profiles of the DM and EM investment universes.

In emerging markets, high-yield debt encompasses bonds from corporate issuers as well as quasi-sovereign issuers, which results in a strong correlation to sovereign risk. And while fiscal management is becoming more robust across EM – as our colleagues rightly argue above – it remains the case that exchange-rate fluctuations, currency devaluations, political and social disruptions, nationalisations and appropriations are bigger concerns in EM than they are in developed markets.

In addition, many emerging-market countries lack sufficient standards to provide accounting transparency and do not have well-defined bankruptcy codes to provide creditor protections in the event of default.

So, while there are plentiful opportunities to be found in the EM debt universe, we think they are best pursued as part of a dedicated EM strategy, with a global high-yield allocation providing investors with pure developed-market credit risk. In this case, it’s best to keep things separate. Like cats and Christmas trees.