Bond Voyage

Read this article to understand:

• How an improving cost of carry could affect the attractiveness of US Treasuries
• The opportunities we see in 2025 for high yield and emerging markets
• The potential impact of rising M&A volumes on investment grade

Welcome to our final edition of Bond Voyage for 2024. As the year winds down, our teams have been busy contemplating the surprises 2025 might hold for bond investors. US Treasuries are taking a breath as the cost of carry improves, high yield stands ready to welcome the year of carry, emerging markets are dancing and dispersing, and investment grade is still reflecting on Black Friday as we consider the implications of rising M&A volumes. The festive season has inspired our themes for this month. Happy reading and happy holidays!

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.

Sovereign debt: Treasuries take a breath

As we head into the end of the year, 2025 outlooks are being published with economic and market forecasts for the coming year. But we know these can be hard to predict.

After a tough few years, 2024 was set to be the year of government bonds, with inflation falling and central banks beginning to cut rates. Treasury returns for the year have instead been on another wild ride:  down three per cent at one point, peaking at five per cent in mid-September, and settling just under two per cent by the end of November. Part of the reason for the lacklustre returns was that no sooner had the 2024 outlooks been published in November 2023 than a set of weak data prints followed by a Fed pivot in December saw the bond market rally aggressively – delivering a seven per cent return in the final two months of 2023.¹

Despite these huge swings in bond yields and returns, the current two-year Treasury yield is close to the level it was a year ago (see Figure 1). Has the market just gone full circle? Not exactly. While yield levels are the same, there are some important differences for bond investors. At the start of 2024, the Fed funds rate was at 5.5 per cent and the market was pricing nearly 250 basis points (bps) of cuts. This left the two-year bond yielding around 4.25 per cent at the end of 2023. The yield is similar today, but the Fed funds rate is now at 4.75 per cent and the market is pricing only 90 bps of cuts. This difference matters for forward investment returns.

The challenge at the start of 2024 was that holding short-dated bonds meant facing a high cost of carry. If an investor had bought a two-year bond back then, the three-month cost of holding the bond would have been a significant 30 bps (see Figure 2). This was because the asset was yielding 4.25 per cent, while the assumed funding cost was much higher, around 5.5 per cent. Additionally, due to the deeply inverted yield curve, the investor’s position would have rolled up the yield curve. This meant that if the shape of the yield curve remained the same, the investor could expect a higher yield and lower price.

The Fed cutting rates and the curve dis-inverting are often seen as a harbinger of a pending recession. For bond investors, it’s an important shift in how the cost of carry is evolving. If the Fed reduces rates further in December as we expect, the policy rate will be closer to 4.5 per cent, and the cost of funding will improve.

By the start of 2025, the three-month cost of carry could drop to only four basis points. If the Fed then cuts again in 2025, the funding rate will be the same as the current two-year cash rate. This means we can extend duration with less of a headwind from the cost of carry. A bond that yields the same rate as the policy rate, with a curve that is flat or upward-sloping, makes the choice between cash and bonds much more balanced. We believe this backdrop will make government bonds more appealing as we head into next year.

The incoming administration in the US is likely to have a different policy stance from the outgoing government. This creates material economic and policy uncertainty for investors to navigate. However, if the bond market finally returns to a positive carry environment in 2025, investors will have time on their side.

2025: The year of carry for high-yield bonds

As we approach the end of 2024, we inevitably turn our thoughts towards our hopes and expectations for the year ahead, all while consuming an unhealthy amount of turkey and chocolate. While the Chinese zodiac marks 2025 as the year of the snake, symbolising intelligence, wisdom, and flexibility, high-yield investors might find it more apt to call it the year of carry.

Market outlook

Despite challenges such as poor valuations and weakening credit fundamentals, several factors are expected to support the high-yield market in 2025.

Fundamentals

The fundamental outlook for US high-yield issuers heading into 2025 remains cautiously optimistic, with overall credit metrics stable. At the regional level, US growth supports earnings, credit metrics, and lower defaults. However, further fundamental tailwinds from easing financial conditions are less likely with inflation stuck above target and the Fed’s wait-and-see approach to policy.

Meanwhile, in Europe, fundamentals are weaker, particularly for industrial companies facing headwinds from softer demand and additional uncertainty on trade tariffs from the US, alongside two major economies without functioning governments.

Valuations

High-yield spreads remain tight, particularly at the higher-quality end of the spectrum, but are well anchored due to supportive fundamentals, especially in the US. With yields around the seven per cent mark (depending on the specific index used), they still provide sufficient compensation if the economic cycle remains firm, though the risk premium is limited for exogenous shocks.

Street expectations are calling for a modest widening in high-yield bond spreads by the end of 2025, offset by lower Treasury yields, which should leave overall yields broadly unchanged. Despite this, the market remains attractive for investors seeking to take advantage of appealing yields.

Defaults

In November, the Moody’s global default rate remained broadly flat at 4.7 per cent from the prior month. Despite the overall decrease in defaults, distressed exchanges (or liability management exercises) remained prevalent.

Looking ahead to 2025, the default rate for high-yield bonds is expected to moderate further to 2.7 per cent, supported by a manageable near-term maturity schedule and a smaller distressed universe.

Issuance trends

In 2025, the market is anticipating a shift towards more net new issuance, driven by increased M&A activity. Gross issuance is expected to reach $320 billion – a ten per cent rise year-on-year – and net new issuance is projected to reach $110 billion, a 65 per cent year-over-year increase.

Conclusion

While the high-yield bond market faces some headwinds, the overall outlook for 2025 is positive. Strong corporate fundamentals and low default rates are expected to provide a solid foundation for investors looking to take advantage of the attractive yields on offer.

As we navigate the year of the snake, the qualities of intelligence, wisdom, and flexibility will be essential for capitalising on the opportunities in the high-yield bond market.

Emerging market debt: Ra-Ra Rasputin, the dance of emerging markets

Loathed and loved, feared and admired, respected and vilified. It’s a matter of perspective. In times of flux, each side of the argument needs to be weighed without personal biases to make better investment decisions. Boney M’s "Rasputin" springs to mind for this month’s emerging-market (EM) theme tune.

Trawling through the research produced since Donald Trump’s victory, the collective market wisdom appears to point to a “red sweep” being bad for EM. Neatly summed up by some as “Trump 2.0”, a stronger dollar, higher yields and therefore financing costs, tariffs and immigration policies might put a dent in remittance flows.

While we don’t argue against this, expecting a carbon copy of the 2016 playbook may be a little naïve. Since Mr Trump left office in 2020, two wars have begun. They have amplified geopolitical risk and uncertainty, complicated supply chains, increased inflation and diverted capital, all with negative spillover effects to EM. We have repeatedly remarked on EM’s resilience in the face of these crises, but an end to these conflicts should have positive effects, albeit hard to quantify.

Egypt should benefit from a recovery in Suez Canal receipts, from conditions that have already much improved in 2024, thanks to IMF and Red Sea land development funding coming through. Lower oil prices would benefit Sri Lanka and Pakistan, both of which are currently engaging with the IMF on reform programmes. Central and eastern Europe, notably Poland, could see support both from reduced fiscal spending on the military and the positive boost to growth from Ukraine’s reconstruction.

We asked both our hard-currency and local-currency managers how they are looking to position portfolios to benefit from Mr Trump’s second term.

Hard currency

We find ourselves drawn to headlines around Donald Trump's appointments and what they mean for policy; the games have certainly begun. However, in all this drama, we see opportunity and an environment that is different from the fear that surrounded his first presidency.

The impact on the emerging universe is likely to be wide-ranging. With higher yields and an adjustment of asset prices heading into the election, we feel able to be on the front foot in the search for opportunities, although we are aware that certain parts of the investment universe will face increased challenges.

As a result, we expect greater dispersion in our positioning to align with the expectation of continued dispersion in asset prices.

Local currency

We are moving towards a more nuanced world following the outcome of the US presidential election. When we draw parallels with Mr Trump’s first presidency, we expect both headline and event risk to increase going forward. However, we see fundamental trends becoming a more prominent factor in the decision-making process, with currency to be an active differentiator. Overall, we expect investors to be more selective in terms of risk allocation.

While the impact on EM local assets could be wide-ranging, it is also important to acknowledge that markets had already been pre-empting the current electoral result to some extent and have moved a fair way to reflect at least a narrow tariff agenda. This has meant the market moves seen since the election have been relatively orderly.

For now, we continue to react to opportunities and position in select markets which have more structural underpinnings. In addition, in markets with improving fundamental stories, especially frontier markets, we still see carry as a largely attractive anchor for select EM risk.

The EM team is also busy preparing for 2025. We recently took a deep dive into Latin America to get ahead of broader regional themes and think about where opportunities might emerge early in the new year.

With elections largely out of the way, the focus in the region is now firmly on fiscal policy. We think the way governments balance the need for fiscal prudence against social spending pressure and a potentially more challenging external backdrop will be key to picking next year’s winners.

In Mexico, the 2025 budget announcement has come broadly in line with expectations but, given assumptions on growth, doubts remain over revenue targets.

Both Colombia and Brazil face near-term fiscal tests. In Brazil, the market is showing displeasure at fiscal laxity. Domestic borrowing costs have gone sharply higher and there is pressure on the currency; however, the government should be announcing a package of fiscal measures to shave tens of billions of reals off the budget deficit. Colombia too will need to announce spending cuts to avoid having to raise financing the market is unlikely to take positively.

Panama and the Dominican Republic have already pushed back on more meaningful fiscal reform for fear of angering investors. Argentina stands out with its strong fiscal policy, but it still faces macroeconomic imbalances and needs to strengthen FX reserves to meet FX debt obligations and regain market access, requiring robust policy measures.

Investment grade: Sales and bargains

With punters around the world cashing in on Black Friday sales, the investment-grade (IG) team is thinking about the bargains global corporates may be fighting over in 2025.

Global M&A is widely expected to make a resurgence next year; Morgan Stanley estimates that M&A volumes rose by 25 per cent in 2024 over 2023 and forecasts a 50 per cent rise in 2025.²

There are various drivers of this resurgence. Global yields are expected to fall as central banks cut rates and global growth is forecast to remain resilient at 3.1 per cent next year, according to the Bloomberg consensus. This makes for a more favourable environment for M&A. Lofty equity valuations driven by expectations of a soft landing in the US have increased seller activity after subdued volumes in 2022 and 2023. And the prospect of deregulation and softer anti-trust headwinds under the Trump administration is adding fuel to the M&A fire.

Some regional variations are expected, with confidence in the durability of the US economic cycle likely to create more fervent dealmaking in the US. Europe meanwhile is still beleaguered with uncertainty as Germany remains stagnant, France struggles with deficits and a debilitated China adds a further drag.

One interesting development on the European side is cross-border banking consolidation, as seen with the UniCredit/ Commerzbank attempt. Our analysts have highlighted Société Générale and Deutsche Bank as being other potential targets, though Europe’s typical bureaucracy remains a hurdle.

The key impact for credit here is the degree to which a rise in M&A affects the credit quality of companies and the amount of supply of bonds to the market. This is especially important as spreads are incredibly tight, floored only by an unshakeable technical of inflows. A worsening in that technical could lead to some weakness. Overall, however, we expect the market will be able to absorb this supply.

Certainly, sell side research expects M&A-related supply to pick up, but Goldman Sachs flagged that large M&A deals this year were relatively bondholder friendly.³ Moreover, with M&A-related issuance typically coming at the long end, demand for such issuance should be strong as investors attempt to lock in higher long-term yields.