Bond Voyage

Read this article to understand:

• How uncertainty and a changing world order are impacting emerging markets
• Why distressed companies face challenges akin to those found at high altitudes
• The lessons sovereign investors can learn from a decidedly un-zen summer
• Why investment-grade investors are looking forward to getting back to old routines

Welcome back to Bond Voyage! As the new school year begins, our teams have been compiling a list of their best summer reads and the lessons these books hold about investing in fixed-income markets.

September also sees the investment management industry welcome a fresh cohort of university and school leavers. To all the new joiners, we extend a heartfelt welcome to the industry. Your journey in the world of investment management is just beginning, and we are excited to see the fresh perspectives and energy you will bring. Best of luck in your new careers, and may your path be filled with growth, learning, and success – and hopefully aided by reading our monthly musings on all things fixed income!

Emerging-market debt: Why it’s important to read beyond the headlines

Summer provides a useful opportunity to reflect on our work and to delve beyond the headlines to better understand what makes markets and economies tick. Here are the books the emerging-market (EM) debt team enjoyed reading over the last couple of months:

1.  The Age of the Strongman by Gideon Rachman

This fascinating book by Financial Times columnist and geopolitics expert Gideon Rachman focuses on the rise of authoritarian leaders and the challenges they pose to democracy and global stability. Rachman describes how “strongmen” with authoritarian tendencies exert control over their countries through manipulation, intimidation and suppression of dissent. He highlights how populist leaders exploit public discontent and use demagoguery to undermine democratic institutions, erode civil liberties and consolidate their power. This poses a threat to the principles – democracy, rule of law, human rights – that are essential for a free and open society.

Another important lesson is the impact of strongman politics on global stability and international relations. Rachman examines how authoritarian leaders like Vladimir Putin, Xi Jinping and Viktor Orbán are challenging the rules-based international order, undermining multilateral institutions, and promoting a more assertive and nationalist foreign policy. This has led to increased geopolitical tensions and a shift towards a more fragmented and polarised world order – themes with big implications for emerging economies.

2.  Thinking in Bets by Annie Duke

In a world that has become more complex, volatile, and therefore uncertain, making the right investment decisions becomes all the more important.

In this context, Thinking in Bets by Annie Duke, a world-renowned poker player and highly regarded author on decision theory, proved interesting reading. One key lesson is the importance of recognising and managing uncertainty.

Just like in poker, investing involves making decisions with imperfect information and with the outcomes uncertain. In the market, there are always risks and unknown variables that can impact the outcome of an investment. By acknowledging and evaluating these uncertainties, investors can make more-informed decisions and, ultimately, better assess the potential risks and rewards of each investment opportunity.

Thinking in Bets teaches us that successful investing is not about predicting the future with certainty, but rather about making decisions based on the available information and the probabilities involved. By embracing uncertainty, thinking probabilistically, and adopting a strategic mindset, investors can improve their chances of achieving long-term success.

3.  Multicurrency Mercantilism: The New International Monetary Order by Kathleen Tyson

It’s not often you come across a book on a relatively serious (even geeky) subject that’s written in such an approachable way. Kathleen Tyson leverages her deep understanding of the architecture of global trade, finance and markets to assess recent market developments and the evolving geopolitical landscape, without the often sensationalist tone that can be evident when other authors tackle subjects such as “de-dollarisation”.

Tyson’s view is that a new international monetary order is emerging as the global East and South transition from the “unipolar” dollar order prevailing since World War II towards what she calls “multicurrency mercantilism”. Time will tell whether this new order fully materialises or not; however, as EM investors, we can already observe some of these themes at play. For example, we are witnessing increased trade in domestic currencies between emerging markets, with potential implications for commodity markets and the resilience of domestic economies.

We found two main takeaways from the book. First, despite the well-documented potential for global geopolitical fragmentation and the associated uncertainties, many of these shifts potentially provide a positive economic catalyst for EM countries, should they be able to adapt. And second, if some of these themes play out, and if we achieve a tangible rerouting of capital by some of the world’s largest countries, we could expect a strengthening of the relationship between the changing geopolitical landscape and financial markets. Exciting times for active investors. 

4.  Istanbul: Memories and the City by Orhan Pamuk

Three members of the team went to Turkey this summer, both an excellent trade for the team this year and an interesting holiday destination. Ahead of the holidays, this memoir by Orhan Pamuk made the rounds. It recounts (or maybe reinvents) the author’s memories of growing up in Istanbul in the 1950s, 60s and 70s. The book also touches on Pamuk’s wider family history to extend the timeframe back to the 1920s and 30s.

The novel contrasts the experiences of three generations during a period of rapid growth and change in Turkey. As well as his home life, Pamuk discusses his country’s glorious past and contested history. He sees the complexities of religion and class adding to the confusion and melancholy of people around him, as they are caught between Turkey’s traditional values and Western culture. The Bosporus Strait, a waterway of enduring importance for transport and trade, runs through the heart of the city – and of the book. Through changes in society, the Bosporus remains a beautiful and refreshing source of light relief, diversion and escape.

Pamuk’s return to Turkey – he lives in the family apartment in Istanbul today – is testament to his fascination and love for the city and country. Altogether, his work, including this book, is highly recommended for the deeper insight it provides into Turkey’s rich history and contemporary complexities.

High yield: Risk management at high altitude

This summer, the high-yield team journeyed to the highest point on Earth through the story of George Mallory, as told by Mick Conefrey in the book George Mallory and the Tragic 1924 Everest Expedition. Mallory was last seen alive just over 100 years ago, in June 1924, a mere 250 metres from the summit of Mount Everest, 29 years before Edmund Hillary and Tenzing Norgay became the first confirmed climbers to reach the summit. His expedition contains some useful lessons on risk.

In mountaineering, oxygen pressure reaches hazardous levels at altitudes above 8,000 metres. For corporations, this could be likened to the zone of insolvency, where companies face financial distress and must act to survive, usually through restructuring.

Investment decisions on companies in this hazardous zone need careful consideration. In distressed scenarios, attention often focuses on the issuer’s performance and legal actions, but conflicts among creditors with competing priorities are common.

Investor alignment significantly impacts restructuring processes (e.g., Chapter 11 or English Scheme of Arrangement) and outcomes (i.e. recoveries). Whether creditors unite, cave under pressure or fight each other has a huge influence on the outcomes of distressed situations.

In the recent restructuring of a French telecommunications company, senior secured creditors have entered into cooperation agreements to signal an alignment of interests. This strategy is intended to help them negotiate better terms – which may involve wiping out unsecured noteholders.

Another recent example comes from the restructuring of a credit management company currently undergoing a financial restructuring. In this case, creditor groups are focused on maintaining or challenging the order of priority based on the maturity dates of the bonds they hold.

When companies are in the zone of insolvency, game theory and access to information become as important to delivering good outcomes as sound credit analysis. Structural, legal, and temporal seniority have all been upended in recent restructurings. The increased complexity of these situations leads to increased uncertainty and, occasionally, attractive risk-adjusted investment opportunities for those who can successfully navigate them.

When asked why he was willing to risk his life to climb Mount Everest, Mallory famously replied: “Because it’s there.” For high-yield investors, the current environment of relatively benign credit conditions and attractive yields on offer can provide a similar allure. However, when conditions change, investors will need to be able to adapt quickly.

Global sovereign debt: Zen and the art of portfolio management

It is a feature, not a bug, that the market throws curveballs at investors. Unfortunately, knowing that is the case offers scant comfort when the unexpected happens.

August proved a challenging month for rates investors in recent years, as initial moves were exacerbated by summer illiquidity to drive outsized volatility. In 2022, Russia’s move to turn off the gas supply to Europe was the catalyst, with UK fiscal concerns adding a vicious kick. In 2023, it was higher US bond supply and stronger economic data that challenged the market’s appetite for bonds.

In 2024, we got the unwind of the yen carry trade. This contributed to another volatile August. The Bank of Japan’s (BOJ) interest rate hike at the end of July, and a soft US employment print that same week, helped drive a rally of around ten per cent in the yen since mid-July. A stronger yen reduces inflationary pressure and domestic corporate profitability.¹

The one-month move in the yen was a four-standard-deviation event.² This triggered a similar four-standard-deviation one-month move in equities that was largely compressed into just three trading sessions. The Topix, the index that tracks all of Japan’s major domestic companies, dropped 20 per cent between July 31 and August 5. This was the biggest three-day drop in the entire history of the index – which goes back to 1949!

The Japanese rates market experienced similarly large moves, with the ten-year Japanese government bond yield rallying 27 basis points (bps) over the same three days. Unfortunately, like many rates investors, we were positioned short. When we re-assessed the position ahead of the BOJ meeting, we believed the prospect of a rate hike was underpriced. That view was correct – the BOJ did hike after all – but we failed to recognise the danger posed by the yen in time and we underestimated the market’s ability to switch to a recessionary narrative so quickly in the US. That first week of August was painful.

To find comfort, this month I have been re-reading Zen and the Art of Motorcycle Maintenance by Robert Pirsig. It is a book full of wisdom with much to offer.³ One element is particularly relevant this month: Pirsig’s idea of “gumption”.

Gumption is the “psychic gasoline” that keeps you going. “A person filled with gumption doesn’t sit around dissipating and stewing about things. He’s at the front of the train of his own awareness, watching to see what’s up the track and meeting it when it comes. That’s gumption,” Pirsig wrote.

He then talks about “gumption traps”, which destroy gumption. An example of a gumption trap occurs when you face a setback and are thrown off course by “conditions that arise from external circumstances”. Gumption traps “drain off energy, destroy enthusiasm and leave you so discouraged you want to forget the whole business”. For a book published 50 years ago, it offers an uncanny description of some of the emotions we felt in early August.

On August 5, with Japanese equities 20 to 25 per cent off their highs (thus tightening financial conditions) and the yen around ten per cent stronger (thus reducing imported inflation), we were forced to question the trade rationale for our short rates position. How do you deal with a gumption trap when it occurs? Turn the setback on its head and treat it as a new puzzle to be solved.

Our hypothesis that day was that, while the US labour market was rebalancing, fears of US recession were overblown. Initial jobless claims data were likely exhibiting some residual seasonality and, if so, they should decline in the coming weeks. The Atlanta Fed’s nowcast of real GDP growth for the third quarter of 2024 (Q3) had been tracking between two and three per cent year-on-year – above trend. However, we felt there was a risk market volatility could spill over onto Main Street, just as Credit Suisse got caught up in the Silicon Valley Bank collapse last year. But we were comforted by the release of a strong nonmanufacturing ISM survey (Services PMI) and the rebound in equity markets.⁴ We were still wary, but felt conditions were in place to begin carefully opposing the moves where appropriate. 

The BOJ has been telling investors for some time that it perceives the neutral rate to be somewhere around one per cent. The labour market is tight, inflation expectations remain high and there are encouraging signs that annual Shunto wage negotiations are feeding through into consumers’ pockets. After the rate hike to 0.25 per cent and the rally in yields, the spread between yields and the policy rate compressed to the tightest levels since the end of yield curve control.

Given the move in yields and a view that a gradual hiking cycle was still the base case, we believed asymmetry in the position had actually increased – especially in the front end of the curve that is less likely to be influenced by mark-to-market swings in global fixed income. So, we added to our short position that week.

We suspect the main risk to the trade comes from a more significant US-led global slowdown. Since adding to the trade, we have focused on building the portfolio in a way that allows us to mitigate that risk, allowing us to be patient until market pricing is a fairer reflection of the BOJ’s messaging.

Investment grade: Roll with it

As the investment grade team returns to “school” after the summer break, which was full of both heroic sporting achievements and market volatility, many will be glad to get back into the old routines.

The back-to-school period is also a time for catching up with old acquaintances, and there are not many older than our Mancunian friends the Gallagher brothers, who have set aside their differences to announce an extensive (and lucrative) reunion tour. To celebrate, we’ve been reading the book Oasis: What’s the story? by Iain Robertson, which looks at the birth of the band and their life on the road before their spectacular break-up.

As we contemplate markets, our “Masterplan” remains that you have to “Roll with It”… That is, make sure you have enough carry in the portfolio but don’t get caught looking “Up in the Sky”. We are mindful that very few businesses “Live Forever” and that returns in credit markets can very easily “Slide Away”.

However, the technical support for the market means we are “Standing on the Shoulder of Giants”, and those concerned about a maturity “Wonderwall” have seen these concerns ease over the summer.

Nevertheless, buying bonds has become almost as challenging as buying Oasis tickets, although for now supply seems to be meeting that strong demand. For those who are “Married with Children”, there will definitely be a sigh of relief when tickets are secured and the kids are settled back in school.