Bond Voyage

Read this article to understand:

• How rates curves have steepened since the summer
• Why the high-yield market is shrinking
• How emerging markets have changed over the last 20 years
• How real estate struggles might affect investment-grade bonds

A warm welcome to the second instalment of Bond Voyage, a new series where we – an assorted crew of hardy veterans and more youthful members of our fixed-income team – 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 to: gcs.creditinvestmentspecialists@avivainvestors.com.

Global sovereigns: All eyes on the bear (steepener) 

We at the global sovereign bond desk are big fans of the hit television series The Bear, which concerns a world-renowned chef who returns to his hometown of Chicago to run his late brother’s neighbourhood sandwich joint. It’s fun, dramatic and, at times, nail-bitingly tense – a bit like bond investing.

On that note, we have also been preoccupied with another sort of bear in recent weeks – the so-called “bear steepening” of the yield curve.

This year has been a tale of two halves for US Treasuries. The start of July marked the low point of the Treasury yield curve, which was at its most inverted in the last few decades, driven by the rapid tightening of monetary policy over the last 18 months.

Since August, however, we have seen a huge steepening of the curve, with long-dated bond yields rising faster than those on shorter-dated bonds.

Opinion on the reasons for this vary. Some commentators point to the huge increase in expected bond supply; others to expectations of higher-for-longer rates thanks to robust US growth; others still to changes in the Bank of Japan’s monetary policy.

Looking ahead, this curve steepening has important implications as it removes one of the key headwinds to owning longer-dated US Treasuries. Given the rebuild in term premia (the excess return an investor now earns on a longer-term bond), we believe there will be more support for government bonds going forward.

Our base case remains that government yield curves will continue to steepen as central banks eventually ease policy to a greater extent than is currently priced by the market. 

High yield: Honey, I shrunk the market!

Reminiscing about the golden age of 1980s film is one way our global high-yield team decompress. And recent market dynamics bring back memories of the science-fiction classic, Honey! I Shrunk the Kids, in which Rick Moranis plays a mad inventor who accidentally miniaturises his own children.

Among the many major events of 2020, the high-yield market took in a deluge of fallen angels (formerly investment-grade bonds that suffered ratings cuts to junk status), with over $172 billion from US issuers alone.¹ While this helped improve the average rating of the high-yield market, most of this debt has since rebounded back into investment grade. In late October, carmaker Ford became the latest issuer to make the leap back into the IG indices (as discussed in last month’s edition of Bond Voyage).²

Since its peak in July 2021, the index has compressed by 18 per cent, or around $385 billion (see Figure 2).^3,4 Whilst this contraction has been accelerated by recent upgrades, issuance in 2022 was at a record low and 2023 is not likely to be much better. All of which leaves the global high-yield market roughly back to the size it was in the second quarter of 2015.

In our classic 80s film, the tiny children face all sorts of mortal threats – from giant raindrops to whirring lawnmowers to hungry scorpions – before they are restored to normal size. But the shrunken high-yield market has brought some benefits for investors.

The BB-rated basket now accounts for a larger weighting and CCC-rated credits a smaller share, which could be an important factor going into an economic downturn. In our view, the significant contraction in the size of the market is acting as a supportive technical tailwind to credit spreads/prices, as investors ultimately have a much smaller pool of assets to invest in.

We believe this is one of the key factors that has bolstered high-yield credit spreads year-to-date and reflects the resilience the market has shown during another year of uncertainty.

Emerging-market debt: Where is the love?

This month’s update finds the emerging-market debt (EMD) team in a reflective mood. Having recently flown back from the International Monetary Fund (IMF) meetings in Marrakech, which coincided with the latter stages of the Rugby World Cup, we started to think about how the world has both stood still and changed over the last 20 years.

Two decades ago it was England, not South Africa, lifting the Web Ellis Cup, whilst the Black Eyed Peas were topping the UK charts with “Where is the love?”

Current outflows suggest there is no love for EMD right now. But while the asset class faces challenges, we would caution against being too pessimistic on what could prove an excellent entry point.

History might contain some pointers as to where things are going, so we consulted the 2003 edition of the IMF's World Economic Outlook. Relief and hope were the prevailing themes, thanks to the perception the Iraq War was close to an end, the waning of the SARS outbreak and the expectation rates might be lower-for-longer. 

But with 20 years of hindsight, we can see much of that hope was misplaced. The damage inflicted on global growth through multiple shocks and a failure to reform, invest and boost productivity over two decades is clear (see Figure 3). The growth downtrend is expected to continue and could prove stronger-than-expected if further shocks materialise.

Rather than relief and hope, this year’s IMF meetings were characterised by relief and fear. Relief, because the EM universe is proving more resilient than expected in the face of macroeconomic uncertainty and rising US rates. Fear, because of the possibility rates and inflation may stay higher-for-longer, coupled with geopolitical and climate risks that could act as headwinds to growth and a catalyst for further price rises.

EM policymakers are busy making plans to deal with these risks, wary of what these could mean for their cost of financing and market access.

With debt now at levels the IMF would have gawped at 20 years ago, the focus at the IMF meetings remained firmly focused on how best to resolve debt restructurings quickly and how to contain future sovereign defaults. 

We expect further defaults, particularly if EM high-yield issuers remain excluded from the Eurobond market and economic conditions worsen. Many of these countries, like Egypt and Ecuador, are already trading at distressed levels.

For us, however, more interesting questions surround countries in the BB and BBB categories – specifically, which are likely to be the next set of fallen angels and which are at risk of more material spread widening. Prudent investors should focus on avoiding risks and readying their buy list.

Investment grade: The Canary (Wharf) in the coalmine?

Private jet. Designer tee-shirt. A rock star’s flowing mane.

Adam Neumann became one of the most recognisable entrepreneurs on the planet thanks to the rapid rise of his co-working empire, WeWork, at one point privately valued at $47 billion.⁵ But Neumann stepped down as CEO in 2019 and the business has struggled: on November 7, the company filed for bankruptcy.⁶

What does this have to do with investment-grade debt, you might ask? Over the decades, residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) have become significant portions of both the fixed-income indices and collectives. The option to purchase the top tranche of often floating-rate income streams has become part and parcel of the IG universe.

There were no defaults in this sector in Europe even through the Global Financial Crisis, when some US asset-backed structures came under pressure. Investors recognised holding RMBS and CMBS in a portfolio could provide BBB-like returns for AAA-rated risk, as well as good diversification.

But then COVID-19 hit. The pandemic changed the way we work, affecting flexible-working specialists such as WeWork, which has over $2 billion of debt outstanding.

But these structural changes bring wider implications for the office sector as a whole. Tenants are broadly looking to reduce their footprints to match new demand patterns. Some are even willing to pay hefty exit charges to hand back the keys to rented buildings: Meta paid £149 million – seven years’ rent – to exit a contract on a London office it never even moved into.⁷

One consequence is an increasing bifurcation in the London market between Grade A space in prime City and West End locations (often new-build with BREEAM certification and strong environmental, social and governance credentials), and older, less prime stock in more peripheral locations.  

As well as structural trends, cyclical issues are also weighing on valuations: this mainly has to do with the impact of higher interest rates as central banks look to control inflation. Whilst higher rates can have negative implications for asset valuations, they also have a knock-on effect on the business models of tenants.

The potential impact on the corporate bond markets is significant. Large amounts of debt have been raised against these assets and it is the job of investment teams to value the assets, their future cashflows and longer-term reactions to these structural and cyclical shifts. The main consideration is whether we are being compensated for the risk we are taking.

Canary Wharf has been the topic of recent public focus. Canary Wharf Group, the company that operates the London office district, has been running with higher leverage recently and has £1.4 billion of debt maturing in the next two years. Its business model is expected to come under greater pressure with higher office vacancy rates, and the refinancing risk is reflected in current bond pricing. The company’s debt has also been downgraded by the major ratings agencies.⁸

Canary Wharf is trying to reconfigure the site away from predominantly offices, more towards retail/food-and-beverage space. Over the last five years it has also tried to diversify the tenant mix away from financial services to a more mixed offering, including life sciences and start-ups, with some success.

But questions remain about the future of this kind of real estate complex in the post-pandemic world. As with WeWork, bond investors with exposure to office markets will be watching closely in case this turns out to be the Canary (Wharf) in the coalmine.