Bond Voyage

Read this article to understand:

• Why the high-yield market continues to look resilient through 2024
• How the global election cycle could affect emerging-market investors
• The factors behind record levels of supply in investment-grade credit
• Why government bond investors should keep an eye on the yen

A warm welcome to Bond Voyage, a 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: Time to get active

Life moves pretty fast, as Ferris Bueller once put it. Dare we say it, but we’re already a month in and 2024 is shaping up to be another dramatic year in markets.

January began with a sharp change in market expectations regarding central bank policy. At the close of December 2023, the odds of a US Federal Reserve (Fed) rate cut in March were over 90 per cent, according to Bloomberg analysis of market sentiment. Then, as the market is wont to do, it changed its mind: the probability of a March rate cut had nearly halved to 50.3 per cent as of January 29 (only a couple of days later, Fed chair Jerome Powell all but ruled out a rate cut in March following the latest Federal Open Market Committee meeting on January 31). We have seen similar shifts in expectations as to the likelihood of rate cuts on the part of the European Central Bank and the Bank of England (see Figure 1).

The question markets are still grappling with is whether central banks can successfully navigate a soft landing; that is to say, can they pre-emptively cut rates before the employment markets take a hit? History would tell us this isn’t likely – often, Fed cuts have come just before a spike in unemployment, but that could be as much correlation as causation. For us, the more important question is: how will the high-yield market be affected by these dynamics?

In our view, high yield doesn’t require strong economic growth to do well. That isn’t to say a soft landing wouldn’t be good for the asset class – of course it would; the combination of falling inflation and a growing economy (even if growth is slow) would likely result in further spread compression and the potential for relatively attractive total returns. It is only to say that if a soft landing isn’t achieved, the outlook for high yield is not all negative.

A lot of attention has been paid to the oscillating correlation between bonds and equities over the last few years. It’s worth remembering a key difference: unlike stocks, bonds do not necessarily rely on the performance of the economy. What does matter in high yield is an issuer’s ability to service its debt by meeting its interest payments.

In our view, a continued high interest-rate environment, which is likely to lead to slower GDP growth, or even a short period of mildly negative growth, is unlikely to drive a significant increase in defaults – particularly given the overall quality of the high-yield market is higher than in the past (as discussed in last month’s Bond Voyage).¹

That view is backed up by rating agency Moody’s latest projections, which show defaults peaking at 4.9 per cent this quarter before declining to 3.7 per cent by the end of the year (see Figure 2). From an investment perspective, we believe this means high yield can deliver similar returns to equities in 2024, but with less volatility.

A lot of the struggling issuers in the high-yield market left the index following the economic impact of COVID-19, and since then we have seen corporate issuers behave more sensibly in managing their balance sheets.

Interest-rate coverage ratios (which measure the ability of a corporate issuer to service debt using its profits) remain high (at around 4.5x), and while leverage levels have increased (the gross figure is just above 4x), they remain modest by historical standards.² As in 2022, most bond issuance last year was used for refinancing maturing debt as opposed to M&A or leveraged buyout activity, and we expect this trend to continue through 2024.

We are also anticipating a greater bifurcation in the quality of issuers seeking to refinance. Double- and single-B-rated issuers are likely to tap refinancing more easily, while the riskiest segment of the high-yield market, those issuing triple-C rated debt, may struggle.

Many people’s new year resolutions have already been dropped by February, but unlike all those whose gym memberships will go unused this month, the high-yield team is keen to stay active. And, in investment terms, active management is key to taking advantage of the greater dispersion we are seeing in high yield, among all quality tiers.

As discussed in last month’s newsletter, we expect greater new issuance this year (we had already seen €7 billion of new issuance in Europe and $30 billion in the US in 2024, as of January 29), which also provides for plenty of alpha-generating potential. The technical backdrop also looks resilient, with near-record rising star activity in 2023 far outpacing the number of fallen angels dropping into the index, resulting in a shrinking of the overall size of the market.

For investors worried about macroeconomic challenges but keen to lock-in high yields, we believe high-yield corporate bonds could offer an attractive allocation opportunity in a well-diversified portfolio this year.

Emerging markets: Breaking the habit

When putting together this month’s instalment of Bond Voyage, the EMD team had the words of rock band Linkin Park’s 2004 hit “Breaking the Habit” running through our heads. Breaking bad habits is, of course, a common theme at this time of year; on the EMD desk, we are in the business of trying to figure out which countries will kick their overspending habits.

With a series of major elections in focus in 2024, it’s worth taking a step back to consider the global picture. First, some context: 72 per cent of the world’s population – 5.7 billion people – live in autocracies, the highest level since 1986. For those citizens lucky enough to live in a liberal democracy, we’re thinking about what type of choice they will have when going to the ballot box in 2024, and whether they will shun populists in favour of more technocratic candidates. 

According to a report this month from the Tony Blair Institute for Global Change, the number of populist leaders has declined from a near all-time high of 19 in 2019, to 12 in January 2024, near a 20-year low.³ The context is the harsh economic reality of the post-COVID era, when leaders have often been unable to follow through on their ambitious promises, leaving voters ready for change. Understanding the social dynamics that lead to electoral shifts, and changing policy preferences by voters, forms an important part of how we assess potential opportunities.

In 2023, we saw the defeat of the Law and Justice Party (PIS) in Poland and the Peronist coalition Frente de Todos in Argentina. This followed in the wake of the departures of Jair Bolsonaro in Brazil; Janez Janša in Slovenia; Rodrigo Duterte in Philippines; and, after his country’s economic collapse, Gotabaya Rajapaksa in Sri Lanka – all leaders who have been described as populist. 

But when looking at a country’s prospects, it’s important to pay attention to the specific political and economic circumstances in each case – after all, not all populists are alike when it comes to fiscal policy.

On the desk, we’ve been focusing on what the 2024 election cycle might mean for more fiscally challenged countries, and whether there may be potential opportunities to take advantage of. Can South Africa credibly commit to consolidating its budget during an election year in which the African National Congress (ANC) faces a graver challenge to its grip on power than ever before? Can Mexico’s new administration realistically promise fiscal consolidation even if it doesn’t fully turn the page on six years of the ever-popular president Andrés Manuel López Obrador, or AMLO (who is constitutionally barred from running again)? What about a country like Indonesia, which has enjoyed very robust fiscal performance, but faces a change in leadership – will the candidates really continue fiscal prudence and maintain fiscal space? 

We are also keeping a close (though less worried) eye on the general election in India, where a victory for Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP) is largely expected to result in policy continuity. But India may need to resist the old habit of spending its way to growth and make the hard choice of credibly committing to fiscal consolidation if it is to preserve its hard-earned macro resilience. 

Elsewhere, there are questions as to whether the Ghanaian government holds the line on fiscal prudence into the election, and how the electorate reacts. We also continue to closely follow the performance of the new governments in Argentina and Ecuador, where future prosperity may need to be paid for with austerity now: the economic equivalent of Dry January. 

Turning to EM corporate issuers, last year many companies held off issuing debt at peak rates but now, especially after strong market performance to the end of 2023, borrowing costs look much more reasonable. So management teams face hard choices about when is the best time to issue. As companies draw up their plans for the year ahead, long lists of targets for growth, investment, sustainability and capital structure will require (re)financing. 

The attraction of large, long-dated bonds at lower cost will draw out a range of issuers. January saw some rarer names return to the market, even before the release of full-year results and clear 2024 guidance to investors. More idiosyncratic names, whose ability to successfully raise capital may alter their risk profile, are of greater interest to us, but they are likely to wait to build a clearer picture before looking to come to market.

Investment-grade credit: Dare we mention the “G” word?

Investors in investment-grade (IG) bonds returned from the festive break and abruptly came to their senses, having apparently decided the strong rally at the end of 2023 went too far.

Price action is currently very technically driven. The IG market saw deluge of new supply in the first trading session of the year. However, with markets still bleary-eyed, low new-issue premia resulted in meagre orderbooks and poor initial performance for many of these deals.

But as optimism about the possibility of a soft landing and Fed rate cuts started to return, a wave of inflows began. As of January 29, we had seen $12 billion and €5 billion of inflows into the US and European IG markets respectively, with investors drawn in by the still-attractive yields on offer. A key driver of this demand is the continued rotation of pension funds from equities into fixed income, with IG seen as a “sweet spot” in a potentially slowing global economy.

This robust investor demand means new issues are pricing tighter than equivalent bonds in the secondary market, and the trend looks set to continue despite the uptick in supply. As of January 29, US IG supply stood at a whopping $188.57 billion year-to-date, the heaviest start to a year on record.⁴ As might be expected, dollar-denominated supply of longer-dated bonds remains low as issuers look for cheaper issuance opportunities as yields fall. Meanwhile, overall euro IG issuance is lower versus 2023, but still elevated against January figures from the recent past.

The question is how this dynamic will play out going forward. With the US ten- year yield still some 80 basis points (bps) lower than the highs of October 2023, this may still provide an attractive opportunity for some issuers to secure shorter-term funding.

February is traditionally a weak month for spread performance, but still an active month for primary issuance. This increases the chances of a pullback in the coming weeks, with valuations looking increasingly stretched. Moreover, with murmurings of reflationary pressures still present in the market, a spike in rates volatility could see inflows into the sector stall, especially given the traditional lag between inflows and total return data (and total returns have been negative for 2024 thus far).

Opposing this is the renewed optimism taking hold on the macro front, with strong economic data and in-line inflation prints prompting some investors to dare to whisper the “G”-word – Goldilocks – referring to economic conditions that are “just right” for bonds.

Still, that doesn’t mean there aren’t a few bond bears around. Uncertainty remains high and there is a large range of views on how 2024 will unfold from this point, when the market looks to be priced to perfection. Investors are keeping an eye on the latest inflation figures, US retail sales data and Purchasing Managers Index (PMI) readings in the UK and US, as well as the unfolding situation in the Middle East, where Houthi attacks on ships in the Red Sea have led to a spike in freight costs.

Looking forward to the second quarter, there could be an interesting interaction of two themes: the ongoing lagged effect of monetary tightening versus the positive impulse from easier financial conditions and rising real wages. This brings with it the risk of a slower pace of disinflation than expected, which could lead to more rates volatility.

To add to this, 2024 is a year full of political risk, as a minimum of 64 countries are set to hold elections, including the potential for a second Donald Trump term as US president, which could bring challenges for Europe given the possibility that new trade tariffs will be imposed and military support for Ukraine withdrawn. For now, the market has its narrative and will run with it, but the path back to two per cent inflation is unlikely to be smooth.

Global sovereigns: Japan zigs while the world zags

As global inflation rates moderate, central banks look set to pivot from the fastest policy-tightening cycle in decades. Not in Japan, however.

The Bank of Japan (BoJ), the central bank, faces a different challenge from many of its global peers, as it aims to keep inflation in positive territory after battling 25 years of deflation. Could Japan finally be emerging from its “lost decades” of economic stagnation?

The post-pandemic inflation outlook looks favourable, with the BoJ forecasting inflation will be close to two per cent over the next two years, and with wages expected to rise again through 2024 the "virtuous cycle" between wages and inflation could be taking hold. With the gradual loosening of yield curve control (YCC) – a policy designed to suppress long-term interest rates – over the course of 2023, the BoJ is now set to remove the negative interest rates that have been in place over the last eight years.

With this in mind, our portfolios are underweight Japan as we expect Japanese government bond (JGB) yields to continue to rise as policy support is removed. On the face of it, selling a ten-year bond – which as recently as December yielded only 0.6 per cent – seems like a no-brainer. Yet, as with most things in financial markets that appear too good to be true, the reality is slightly different.

The situation is complicated by differences in the value of global currencies. Foreign investors in Japan can take advantage by securing a foreign exchange (FX) “carry”. Within FX markets, investors can borrow (i.e. sell) in a low interest-rate currency (such as the yen) and fund (buy) a higher-yield currency such as the dollar, sterling or the euro. This earns a positive return based on the interest-rate differential. So, while we are underweight low-yielding JGBs, we have maintained an overweight in cash in yen, which can deliver an attractive risk-free return once the yield from the FX hedge is included.

The attractive FX carry on offer also has wider implications for global bond markets. For many years Japanese investors were able to earn an FX-hedged pick up by buying foreign bonds. This faded after Western economies began raising interest rates and we have seen a significant reduction in these flows over the last few years. For instance, for a Japanese investor who is considering buying US Treasuries but also wants to hedge FX risk, the yield on offer on the US ten-year bond was -1 per cent at the end of 2023 – hardly enticing (see Figure 4).

With Japanese investors being significant players within international bond markets, tracking their activity is important for understanding global capital flows, and FX-hedged yields are therefore worth paying attention to.

If there remains a significant difference in policy rates between Japan and the rest of the world once the BoJ is further along its normalisation journey, and JGBs trade closer to their fair value, JGBs will become more attractive for foreign investors and domestic investors are more likely to favour their own market.