Bond Voyage

Read this article to understand:

• What the big shift in Japanese monetary policy means for government bonds
• Positive developments in Egypt and Turkey for EM investors
• Challenges in the high-yield market
• Respectable technicals in investment-grade credit

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

Global sovereigns: End of an era

In March, Hayao Miyazaki, one of Japan’s greatest filmmakers, won an Oscar for his animated feature The Boy and the Heron. Based loosely on his own childhood, it tells the story of a young boy transported to a magical realm. It’s rumoured to be Miyazaki’s last film for his company Studio Ghibli.

It was the end of an era for another venerable Japanese institution last month, as the Bank of Japan (BoJ) hiked rates for the first time in 17 years, and for just the fourth time since the introduction of the zero-interest rate policy in 1999. In its announcement on March 19, the BoJ also said it would end its yield-curve control (YCC) framework – a policy designed to suppress long-term interest rates – and its exchange traded fund and Japanese real estate investment trust purchases. For a long time, such policies made Japan seem like a Miyazaki-style parallel universe when compared with other major economies; now its central bank seems to be returning to a more “normal” policy approach.

So, a huge moment – but was it a huge moment for the Japanese government bond (JGB) market? Well, looking at the market reaction in isolation, anyone would have thought the BoJ had actually cut rates! Bonds rallied, the Nikkei index rallied and the yen weakened. Given how well-flagged the move was in the weeks preceding the meeting, some “buy-the-rumour, sell-the-fact” behaviour on the day was to be expected. Moreover, the BoJ pledged to continue with its purchases of JPY6 trillion-worth of JGBs per month and indicated it would maintain accommodative monetary conditions going forwards, removing the tail risk of a more aggressive policy stance. Thus, ten-year yields ended the day of the announcement almost exactly in line with the level as at the end of January and are currently still some way off their 2023 peak.

So, what now? While we applaud the BoJ for dismantling the negative interest rate policy and YCC without shocking global markets, it remains in a tricky situation. With the central bank pledging to avoid “discontinuity” in bond-buying operations, this may well encourage further carry trades within both the foreign exchange (FX) and bond markets. As noted previously in this newsletter, there is potentially an attractive FX-hedged pick-up for foreign investors buying JGBs.¹ If the BoJ keeps monetary policy accommodative, is there still a case to be short JGBs?

We believe there is. The first round of Shunto wage negotiations was very strong, which is encouraging for those hoping to see a “virtuous cycle” of wages and prices. We expect this to be confirmed in the upcoming wage negotiation rounds. Sticky services inflation in geographies such as the US, UK and Europe suggests Japan may see a similar dynamic, and a weak yen contributes to imported inflation pressures. This means the BoJ should have greater comfort that its inflation target can be reached sustainably. Furthermore, once the BoJ has digested the impact of removing negative rates, the door may be open to reduce JGB purchases as early as the third quarter. The equilibrium interest rate for JGBs should move higher as a result, but in our view this would be a sensible policy shift, mitigating risks of fiscal dominance and further yen weakness.

It is clear the BoJ is taking an incremental approach. But its caution has helped to support a path to a higher-rate environment. As such, while it will no doubt test investor patience at times, we believe positioning for higher JGB yields remains an attractive opportunity over the medium-to-long term. Our sovereign bond portfolios remain positioned underweight lower-yielding JGBs while maintaining an overweight in Japan cash, which should continue to deliver an attractive risk-free return once the yield from the FX hedge is included.

Emerging-market debt: I’ll be there for you

This month the emerging-market debt (EMD) team has had the theme song from the TV show “Friends” stuck in our heads. After all, sometimes even emerging markets sometimes need friends in high places.…

Egypt has certainly been stuck in second gear for a while now. A derailed International Monetary Fund (IMF) programme and an acute FX shortage had created a backlog of goods stuck at port, a surging parallel exchange rate and weak confidence among both offshore investors and local residents.

But a $35 billion investment deal with the United Arab Emirates (UAE) has prompted fresh optimism. Under the terms of the deal, an Abu Dhabi state fund will purchase development rights to an area on the Egyptian coast.² There is no denying the UAE’s financing has triggered a virtuous circle that has put Egypt firmly back on investors’ radar. The size of the deal was complemented by decisive action from the Egyptian authorities: a 600 basis point (bp) unscheduled rate hike, allowing market forces to determine the Egyptian pound's value, and the announcement of an upsized programme with the IMF.

Coming in quick succession, these steps did exactly what Egypt needed to induce a positive confidence shock. Now, the authorities seem intent on continuing with a pivot to more orthodox policy, which we will be watching keenly in coming weeks. The magnitude of incoming recent inflows, both from official and private sources, suggests Egypt has a real opportunity to turn things around. Looking at the extent to which prices of Egypt sovereign bonds have moved, we have taken our chips off the table; but local-currency Egyptian debt looks extremely interesting at current levels.

Across the Mediterranean, another orthodox policy pivot continues to play out in Turkey, though with more challenges. Initial investor enthusiasm has given way to some doubts over the efficacy and longevity of the policy shift. But those doubts will likely be put to one side after President Erdogan re-iterated his support for his economic team and the focus on fighting inflation despite a stinging defeat in the municipal elections at the end of March. With no other elections until 2028, Turkey now has time to watch those policies play out, help anchor local sentiment and trigger foreign inflows. If this happens, Turkey could once again be the trade de jour.

Looking across the Atlantic to Mexico, PEMEX – Petróleos Mexicanos, Mexico’s 100 per cent state-owned oil and gas group – has a friend in the form of President Andrés Manuel López Obrador (known as AMLO), whose government has supported the company with capital injections.

But the company is facing challenges such as stagnant production, and the political landscape could become less favourable. The election in June is likely to spotlight questions around energy policy – such as how best to access and finance secure, clean and affordable energy – and we could see changes in hydrocarbon taxes, and the level of private investment in oil and gas.

However, PEMEX recently published its first Sustainability Plan, a vital step to meeting the environmental, social and governance (ESG) requirements of lenders in order for them to renew loans and for PEMEX to regain access to international bond markets. If it satisfies investors’ ESG standards, this could unlock opportunities for refinancing external debt and give PEMEX more time to make progress. A poor ESG track record has been one factor behind investors’ waning interest in the credit.

Global high yield: The tail wags the dog

Well, it was nice to enjoy the rally in high yield spreads over the last five months. But in late March we discovered what happens when higher interest rates meet highly leveraged companies with weak covenant and security packages for bondholders. Proactive and aggressive liability management by shareholders in three companies with large debt capital structures – Intrum AB, Altice France and Ardagh Packaging – is currently causing market jitters.³

Whilst these issuers and related entities only account for a total of 1.8 per cent of the global high yield market and 3.5 per cent of the pan-European high-yield market, the recent announcements that these firms are set to appoint financial advisors and pursue options in creditor documents is having profound implications.⁴ First, regarding credit analysis, it has put the focus back on understanding security packages and weak documentation, which have unfortunately become the market norm for the best part of the last decade.

Second, it highlights that the ability to pay is not the same as the willingness to pay. The three issuers are not facing unmanageable imminent maturities; their near-term maturities can be met with existing liquidity and asset disposals. It has been the choice of the companies to begin active negotiations with bondholders to cut their unsustainable debt burdens.

Lastly, whilst the “long-CCC” trade has been an easy one lately, the expansion of the CCC-rated market with downgraded bonds shows even greater attention must be paid to active management, particularly for European high-yield investors, where the trajectory is likely to remain volatile as issuer-creditor negotiations proceed. The three distressed structures are unlikely to result in systemic and contagion risk, but they are shaping the returns and risk-reward profile of the broader high-yield market, with euro-denominated CCC spreads already significantly underperforming and dragging on total returns.

Investment grade: Technicals looking respectable

Concerns are rightly being raised around credit market fundamentals after a tumultuous period for European high yield. But looking at the rest of the credit market, you wouldn’t necessarily notice.

After a strong start to the year for investment-grade (IG) credit spreads, which are at near-historic tights, heightened nervousness as to the potential emergence of systemic risks is not unexpected. There are the usual questions around whether the distressed issuers will have knock-on effects on other parts of the credit market, but the answers lead us back to the same argument: technicals remain very firm across the market and do not seem to be showing any signs of trouble.

With the risk of default within IG typically close to zero and valuations looking like they will stay tight for some time, technical factors are understandably a driving force behind the direction of IG spreads and yields for the time being. When faced with a combination of yields, which are touching new highs for the post-Global Financial Crisis period, central banks with dovish aspirations, and a stable macro environment, the demand backdrop is positive. Steady inflows from institutional investors looking to lock in duration, but also yield-sensitive investors looking for a premium to government bonds, seem to indicate less concern with spreads in isolation. While supply was record-breaking in the first quarter, demand has proved more than sufficient to match it. Supply is set to slow down for the remainder of the year, which will likely keep downward pressure on spreads for now, especially considering maturities and coupons are generating strong sources of organic demand.

Caution is necessary, however. Lower-quality issuer spreads are compressing against higher quality at a rapid pace and are looking stretched as a result. Dollar-denominated BBB-rated bonds’ premium to single-A-rated equivalents was at 33bps as at March 27, the lowest level since 2001, and dollar BB-rated bonds’ premium to BBB-rated bonds was down to only 76bps on the same date, also near all-time lows.⁵

Monetary policy remains restrictive and certain vulnerable issuers are priced to perfection. These very technical markets will drive volatility and dispersion lower as less value-discriminating buyers dominate the market. But this could lead to a significant dislocation between valuations and fundamentals within sectors and rating buckets, so an active fundamental approach is still required to generate genuine alpha and avoid mispriced securities.