Bond Voyage

Read this article to understand:

• Why market jitters in August should come as no surprise
• How geopolitics may influence winners and losers in EM debt
• The parallels between BMX and global sovereign bonds
• Why it may be time to dive into investment-grade credit

Welcome to the latest Bond Voyage newsletter. In the midst of a busy summer of sport, our teams have been pondering how to win the fixed income equivalent of a gold medal – despite the market ructions that interrupted summer holidays in early August.

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

Liquidity: Not such a quiet summer…

During the summer, we should all be settling in to watch sport on the television or cracking on with a beach read. Markets had other ideas.

Current market conditions do not call for passively responding to events, but actively seeking out opportunities. But should the turmoil of this August really come as a surprise? History would suggest not.

August has seen its fair share of upheavals. Cast your mind back to August 48BC and the Battle of Pharsalus (Caesar won, creating the Roman Empire); or to August 1485 AD and the Battle of Bosworth Field (Henry Tudor won, ushering in the Tudor dynasty and out the Plantagenets). The list goes on. Did you know the first casualties of the Great Financial Crisis began emerging in, you guessed it, August 2007 (in asset-backed commercial paper)?

More recently, an intriguing event in South Africa delivers an enduring lesson for why credit analysis always, always, counts. African Bank, a small South African bank, was placed in curatorship over the weekend of August 11, 2014. The bank was restructured, with junior creditors wiped out and senior creditors written down by ten per cent instantaneously. What made the case interesting was that African Bank was widely held by local money market funds (MMFs). In other words, this was an example of a credit default affecting a wide swathe of MMFs – but not every fund. The evidence shows some funds, which could have held African Bank – as it was rated sufficiently highly to be eligible for inclusion in their portfolios – had chosen not to hold it.

And there’s the lesson. Good credit analysis, combined with environmental, social and governance (ESG) analysis, can mitigate default risk. As it happens, the South African MMF industry shrugged off the default and continued to grow – and a reconstituted African Bank is active to this day.

Now, can you write this off as an isolated event in an emerging market? Unfortunately not. The Federal Deposit Insurance Corporation reports 567 (US) bank failures between 2001 and 2024. While history does not always repeat, it often rhymes. Many of the red flags identified in the past can still be relevant today. Putting it all together, a good credit analyst, following an established process, can identify risks and advise against investment for MMFs.

Wars, defaults and market volatility. August can be a trying month. But there is always another side to the tale. Legend has it that champagne was invented in August (1693). We just hope our reference to bubbles is taken in a positive light!

Emerging-market debt: The EM marathon

Beyond market ups and downs, it has been a brilliant summer of sport, and the EM debt team has been discussing parallels between economic performance across emerging markets and the hunt for medals in athletics. In both areas, focus and resilience are key to success.

That’s certainly the case with Poland, one of the better-performing EM economies over recent years. Team EMD was in the Eastern European country last month, meeting with the central bank and finance ministry, along with local journalists, banks and asset managers. The visit reinforced our conviction that conditions are in place for the economy to continue to perform well, subject to careful navigation of geopolitical risks.

Poland finds itself at an interesting crossroads. A parliamentary election that led to Donald Tusk becoming prime minister last October ensures the country is now one of the strongest centrist voices in Europe. That should guarantee friendly relations with the European Union, enabling the ongoing release of some €6 billion in recovery funds (around eight per cent of GDP), which will be crucial if Poland is to meet its needs for funding and investment in infrastructure, digitisation and the energy transition.

Poland’s growth is likely to be investment-led in coming years, which could help it meet its potential annual growth rate of three- to four per cent. Robust growth will also be important in keeping Poland’s debt dynamics in check.

That said, none of the conversations we had in Poland drifted too far from the political and geopolitical realities that the country finds itself in, reminding us of the near-term challenges to an otherwise constructive outlook. Domestically, the all-important presidential election in May 2025 could alter the current reform trajectory. Regionally, Poland’s security concerns are existential in nature – Russia’s war on Ukraine is too close for comfort – and explains why the country has scrambled to ramp up defence spending. The ability to skilfully navigate these choppy geopolitical waters will be key in unlocking Poland’s full potential.

This speaks to a broader point about EM debt investing in the current environment. Understanding the implications of shifting power dynamics, and what they could mean for a country’s relative economic performance and political and policy choices, is crucial.¹ As with any long-distance race, those hoping to pick out the prospective winners from the losers will need to pay close attention.

Global sovereigns: Of bikes and hard landings

Whilst traditional sporting events get a lot of the attention over the summer, the global sovereigns team found ourselves drawn to a slightly more unusual sport: BMX racing.

For some reason, something resonates about competitors who must navigate a course featuring ups and downs and twists and turns, managing huge risks to reach the finish line. We strongly suspect that if you put a side profile of the track together with a chart of bond yields, the resemblance would be uncanny. (If only bond investors looked as cool as BMX riders doing their job.)

For the last year, we have focused on keeping our strategies in a straight line, targeting a scenario where the Federal Reserve delivers a “soft landing”. This is a scenario where inflation falls back to target without a recession and a significant rise in the unemployment rate. Over the year we have seen huge ups and downs in market pricing of this scenario, not least with the false start at the end of last year, where the Fed signalled a pivot towards easing monetary policy before a series of higher inflation prints in Q1 forced it to backtrack. Staying invested in the soft-landing scenario has meant having a firm grip on the handle bars.

Earlier in the summer, we were comforted by the weakness in US inflation prints, where three-month annualised core personal consumption expenditures (PCE) inflation came back below 2.5 per cent, and thus we expect the Fed to begin easing policy from September. From a portfolio perspective, we have navigated this US view by maintaining yield-curve steepeners, with a view that the closer we get to the finish line on inflation progress, the more likely it is that front end-bond yields will outperform, and the curve will finally return to a positive slope.

During the last few weeks, however, it has felt like we have moved on to a completely new course. Sentiment has shifted towards recession fears as recent weakness in survey data and a rise in the US unemployment rate has raised the question of whether the US economy is slowing more rapidly than previously forecast, and therefore requires a more aggressive monetary policy response. The recent rally has taken us through our base case scenario and into our bull case scenario, one where the Fed is required to cut at consecutive meetings.

The July US employment report has taken this even further, with the market now pricing 50 basis points (bps) of cuts from September.² We think that policy rate pricing now looks aggressive and so continue to reduce our steepening risk into this move. We suspect a “buy-the-dip” mentality should limit any larger selloffs to materially higher yields, but there is far less compensation for the uncertain twists and turns that we expect over the next few months. As a result, our US front end and curve views are now closer to neutral.

Where we are seeing value is in market pricing of US inflation. When an economic crisis unfolds, we typically see rates rally while inflation-linked bonds tend to underperform nominal rates (as inflation expectations fall). While we are sympathetic to the view that growth concerns have increased, our base case remains that the US will avoid a recession.

There is a strong consensus that the Fed will begin easing policy in September and we believe these cuts will see inflation expectations be supported. We think the Fed getting back in front of any further weakness will ultimately be supportive for the economy and will give a boost to inflation expectations. Given we are only just coming out of a huge inflationary spike, we believe US break-evens need to trade above expectations of long-term inflation, meaning they should have a positive inflation risk premia for medium-term inflation uncertainty.

Global investment grade: High dive

The path of the two-year US Treasury yield reminds me of one well known sport that you might have been following this summer…. as Figure 2 shows, it’s a bit like watching divers plunging off the high board.

When US jobs data came in weaker than expected on August 2, this seemed to seal the deal in terms of market expectations of Federal Reserve rate cuts later in the year. The two-year Treasury slid 21bps in the opening session, and a total of 49bps over the week, before ticking up slightly on August 5.³

This is a huge move in yield terms and reveals markets’ thoughts on the path of rate cuts in the US, However, we have seen this before. Back in November 2023, the Fed sought to manage market expectations of rate cuts – between then and the start of May 2024, the markets “priced out” six cuts that had previously been priced in.

But conditions are somewhat different in August 2024. For example, big tech stocks have come under some pressure and there has been some rotation out of the “Magnificent Seven” of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. The VIX (stock volatility index) shot up as tech stocks sold off.⁴

What does all this mean for credit? Global investment grade (IG), and indeed regional IG, is at near historic tights in spread terms. ICE BofA Global IG hit lows of 94bps in May, whilst CDX IG (the US IG credit default swap) was trading at 61bps as at August 5.⁵ The last time spreads were at these levels, back in 2021, central banks were still undertaking considerable quantitative easing (QE). This robust back-stop meant defaults were low, as were projections of future defaults. The other big difference is that, back then, rates were at near-zero levels, meaning companies could borrow cheaply with no real worries about the future of the economy or refinancing risk.

Curves have been inverted since mid-2022,⁶ when the rate-cutting cycle really got going and the impact of the pandemic on the global economy was yet to become fully clear. Historically, inverted curves have been a long-run signal of recession on the horizon; as curves start to normalise from this inversion, and credit spreads reach tights, this also may portend a slowdown. So where does that leave us now?

It's worth remembering market yields on global IG are still in the region of five per cent, and July delivered positive returns in both IG and high yield, as the  rates lever got to work.⁷ Defaults in IG are still low, companies in IG have locked in low costs of borrowing for longer, and even companies looking for financing more recently have come to market and sold bonds easily as demand massively outstripped supply. We have said this before, but will say it again: the technical backdrop for IG provides an environment in which corporate debt looks compelling.

Spreads might well widen on this narrative, but with the rates lever alive, there is still a decent buffer before investors would give up yield. So, like that high diver, it looks scary from the top – but there are medals to be won.