Bond Voyage

Read this article to understand:

• Why liquidity investors should chop like Cristiano
• The countries EMD investors should consider for their starting XI
• Why tactical caution is sensible in investment-grade credit
• How the fiscal equivalent of football’s FFP will affect global sovereigns

Welcome to July’s Bond Voyage newsletter. This month, our teams have torn themselves away from coverage of the European Championships to offer their thoughts on the parallels between liquidity investing and the Ronaldo “chop”, winners and losers in emerging-market debt, the cautious tactics required in investment-grade credit, and the lessons of football’s transfer window for global sovereign bond investors.

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: CreditInvestmentSpecialistsDL@avivainvestors.com

Liquidity: Siuuuuu!

Ah, Cristiano Ronaldo. The shy and self-effacing Portugal forward is appearing in his sixth European Championships in 2024, which makes him the first player to achieve the feat.

Or to put it another way, Cristiano, now in his fortieth year, has been a mainstay of the public imagination for a long time – a bit like ultra-low central bank interest rates!

The European Central Bank (ECB) initiated the ultra-low interest rate environment following the Global Financial Crisis (GFC) in 2009 and did not raise rates until 2022. That’s 13 years of ultra-low rates – considerably shorter than Ronaldo’s Euros career (which stretches back to his appearance as a fresh-faced stepover merchant in the 2004 tournament) but still long enough to have a major impact on the investment community’s thinking.

With ultra-low rates etched into the public consciousness – much like the sight of Ronaldo sauntering about the pitch moaning at his teammates – it’s tempting to think these features will be ever-present. But age will eventually catch up with Cristiano, if it hasn’t already. And though markets may well assume that the ECB’s recent 25 basis points (bps) rate cut presages a return to the ultra-low-rate environment, we don’t think so.

While we accept rates will fall, our House View forecasts the ECB cutting to a range of 1.75 per cent to 2.75 per cent by end-2025. A range lower than market consensus, but still well above the preceding ultra-low, and indeed, negative, rate era.

So how should investors, particularly liquidity investors, position for this environment? Ronaldo provides a clue with his famous chop: a deft way of bypassing defenders by “chopping” the ball between the legs, allowing a sudden change of direction, often followed by a shot.

For investors, two lessons emerge: First, skill comes to the fore. A rate-cutting cycle does not just mean adding duration. Successfully managing the glide path requires situational awareness and dynamic duration positioning, just like the choice to chop left or right at the decisive moment. Which of course brings us to our second key lesson: changing market environments create opportunities for active investment managers. And hopefully a few more goals!

Emerging-market debt: Winners and losers

Following the action from the Euros in Germany, you might have heard the tournament’s official song, “Fire”, blaring from the stadium speakers. A collaboration between electronic trio MEDUZA, pop group OneRepublic and German singer-songwriter Leony (together at last!), the track features some unusual lyrics…

Those of us on the EM team who would rather analyse data than watch football (or do pretty much anything else), have recently put together our bi-annual “slice and dice” exercise, a mid-year performance appraisal of EM countries and our first attempt to think about the likely winners and losers in 2025.

To use a footballing analogy, our job as active EM investors is to make sure we pick the Mbappés, Kanes and Rodris of the EM world, rather than being knocked out in the debt investors’ equivalent of the group stage.

So, who might you pick for your 2025 EM squad? Well, that depends on the type of pitch you’re playing on. If 2025 looks much like 2024, perhaps with slightly weaker growth and lower rates, then duration and select high-yield debt that still has some “spread” left is the way to play the game. Bonds from the likes of Ecuador, Egypt and Argentina should benefit from easier financing conditions.

If, however, US rates do remain at elevated levels for an extended period, then EMD investors need to be more selective on which players to put on the pitch. With EM central banks now fighting the “last mile” of inflation, higher global rates risk keeping policy settings highly restrictive, a situation which can quickly become politically unpalatable, especially in the most fiscally vulnerable countries.

Higher rates not only mean higher debt-servicing costs but potentially weaker growth as well. As debt nerds like us know well, that makes the “r-g” differential – which refers to the difference between a country’s real interest rate and its real GDP growth rate – less favourable for debt reduction (see Figure 1).

More importantly, it makes it potentially unrealistic to expect policymakers to tighten fiscal belts during or in the run up to election years. In that kind of scenario, fiscal metrics in Central and Eastern Europe, Colombia, Brazil and Mexico would be challenged. Meanwhile, the likes of India, Chile and Philippines would have sufficient growth buffers relative to interest and primary burdens to withstand pressure.

We would also expect a greater degree of dispersion among investment grade/cross-over credits, like Colombia, Mexico and South Africa (countries to the right of Figure 1, where debt dynamics already have an unfavourable starting point). Those that are willing to undertake fiscal consolidation to offset the potential impact of higher rates will remain part of the team. Those that continue to spend unsustainably could face being relegated to a lower rating category.

Global investment grade: Grinding out results

With an action-packed summer of sport ahead of us, starting with the Euros, it’s difficult to remain focussed on credit markets, but fortunately for us there are many parallels to draw.

In the early stages of the Euros, many of the leading contenders proved rather lacklustre – rather like the spreads currently on offer in global credit markets. Credit spreads have continued to tighten in 2024 and are now on the tighter side of fair value in our view. Expectations, however, remain difficult to manage, as much for end investors as for national football team managers dealing with hostile media questions and fans hurling beer cups. 

Away from the football field, politicians are also struggling to manage expectations, as voters express discontent. Recent developed-market democratic election cycles have proven challenging as for the first time in many generations living standards have declined over a prolonged period. There was a significant underperformance of French assets in the lead up to the snap election called by President Emmanuel Macron, a situation we expect to continue, but we will be monitoring that market closely for opportunities into the summer as the Paris Olympic Games get underway.

The feature of credit markets that continues to win gold medals is the technical backdrop. Indeed, across economies and markets, the end demand backdrop remains robust. It is easy to see why, with so many major public events packed into the summer calendar, service-sector demand remains so strong. For sports fans as well as investors, it is hard to stay focused on the big picture. With yields overall within global investment grade remaining near their post-GFC highs of 5.5 per cent, we continue to view this overall yield as worthy of a place in investors’ starting line-up.¹

Global rates: All eyes on Europe

The influence of the Euros will last long after the tournament is over. Once the referee blows the full-time whistle in the final, we head straight into the wheeling and dealing of the pre-season transfer window, where the medium-term value of many players will be shaped by their performance in Europe's top competition.

The “Financial Fair Play” regime was brought into football to ensure clubs don’t spend what they don’t have. Of more interest to global sovereign investors is the Stability and Growth Pact, whereby European countries agree to sound public finances.

The corrective measure for this is the Excessive Deficit Procedure (EDP); the regulation states member states under an EDP have to adjust their structural budget balance by 0.5 per cent of GDP annually to bring it back into line. What does this mean in practice? European governments need to start reducing their spending where levels have been elevated in response to the pandemic. EDP were issued on June 26 to France, Belgium, Italy, Hungary, Malta, Poland and Slovakia.

The result of the French election will not resolve the issue of elevated budget deficits. The same is true in Italy and other countries; they face the choice of fiscal consolidation via either spending cuts or tax increases. Italy will either need to comply or push back against the EU Commission. How the rules are implemented will be the key for how intra-European spreads trade over the coming quarters.

Overall, we think political/deficit uncertainty will persist in Europe and will warrant a more cautious view on spreads from here. There is still the case for divergence, with the likes of Spain, Portugal, Austria and Finland in a much stronger position, and so we continue to favour these markets.