AIQ Editorial Team
In the latest instalment of our monthly series, our investment-grade, high-yield, emerging-market and global sovereign bond teams explore the key talking points in fixed income.
Read this article to understand:
- The return of “frontier” issuers to the Eurobond market
- Potential opportunities in high-yield callable bonds
- The “will they, won’t they” drama of the rates cycle
- The debate about Paris-aligned Benchmarks and sustainability in fixed income
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
Emerging markets: EM bonds are back, alright!
This month the emerging-market debt (EMD) team is paraphrasing the lyrics of a guilty pleasure: Backstreet Boys’ 1997 hit “Everybody (Backstreet’s Back)”. Because EM bonds are back, alright.
We were expecting sizeable issuance in January and February and this came through; just over a third of total expected issuance for the year has already been done. Net issuance will now be negative for the rest of 2024, acting as a technical tailwind for the asset class, particularly once flows return.
Perhaps more surprising has been the ability of three sub-Saharan African sovereign issuers to come to the market in a matter of weeks: Ivory Coast in January, followed by Benin and most recently Kenya. All three issuers got deals away easily, well inside the prices initially mooted. This is important for the “frontier” space, where a lack of market access had raised the risk that ultimately these countries may have needed to restructure their debt if they were unable to refinance it.
We would expect more frontier issuers to dip their toes back into the Eurobond market in 2024, in Africa and beyond. Nigeria, if it continues its reform momentum, and El Salvador, if it reaches an agreement with the International Monetary Fund on a financing programme, might be among the candidates to issue next, provided market conditions remain benign.
In February we were on the ground in India to see for ourselves what the hype is all about. Local bonds are set to start being included on the GBI-EM Index as of June, which could result in around $24 billion of inflows between June 2024 and March 2025, according to Fitch Ratings estimates.1
There is a lot to like. GDP growth at around 6.5 per cent is among the highest in EM, inflation is largely under control, external accounts have seen structural improvements and the fiscal accounts are being consolidated.2 Policy continuity is widely expected despite the upcoming general election in April-May.
There is a lot of hope and confidence in the country. Over the past few years, the authorities have prioritised stability over growth and there is a sense the economy is reaping the benefits of that resilience now. Some of that has been down to luck – India enjoyed a positive terms-of-trade shock that boosted growth and profit margins. But the macro resilience can also be attributed to policy choices and reform momentum.
As a result, India is in the midst of a macro re-rating. The talk of the town is when, not if, India receives a credit-rating upgrade. Whether it does or not, there is no denying India is on the move. Fixed-income investors and other emerging markets should take note.
Global high yield: Something strange in the neighbourhood
Regular readers of Bond Voyage will remember the global high-yield team loves 1980s movie classics, so it shouldn’t be a surprise that we’ve been watching Ghostbusters again.3
Because we are bond nerds as well as film fans, the refrain of Ghostbusters’ theme song, “who ya gonna call?”, got us thinking about HY markets – and, specifically, some interesting dynamics surrounding callable bonds.
Start with some context. Our analysis shows that while option-adjusted spread (OAS) in global high yield continued to tighten throughout February – it was trading well below the long-term average of 540 basis points (bps), and not far off the trough of 248bps seen in May 2007 – the index is pricing most of the market to maturity, which we don’t believe is realistic.4
Which brings us to callable bonds. These are bonds that can be repaid early, at the issuers’ discretion, allowing them to refinance debt at (potentially) lower rates. But in today’s market, something slightly different is happening. Given the fast-approaching and well-discussed maturity wall (see our December 2023 edition) and recent move lower in rates, bonds are trading below their call price and issuers have spotted a window to refinance and push their maturities out.5
Look at the data: between July 1, 2023 and February 20, 2024 a combined $65.5 billion worth of US and European HY debt was “called” from the Bloomberg Global High Yield xEM xCMBS 2% Issuer Capped Index, within an average of 655 days of the maturity date (from a range of 242 days to 2,280 days).6
Over the six months to February 23, OAS in both the US and Europe tightened by -75bps and -99bps respectively, against US and German five-year sovereign yields.7 Financing costs for issuers are therefore much lower today than they were only six months ago, allowing for the reopening of the HY primary market, even for lower-rated issuers.
Using bonds with a call date of at least 300 days before maturity as our sample set, we found the global HY market has more than 25 per cent of this debt outstanding between 2025 and 2027.
Figure 1: Global HY callable bonds maturing 2025-2027 (per cent)
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Source: Aviva Investors, Bloomberg. Data as of February 23, 2024.
As outlined, most of this outstanding debt is trading below its next call price, meaning the yield-to-call is once again higher than the yield-to-maturity as the cash price will likely revert to its call price quicker than expected. The last time we saw this happen was the end of 2021.
Figure 2: Percentage of bonds trading below their call price by maturity date
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Source: Aviva Investors, Bloomberg. Data as of February 23, 2024.
The key takeaway for investors here is that there is something strange in the HY neighbourhood, with callable bonds with short maturities trading below their call price and therefore potentially offering higher returns. And investors don’t need supernatural powers to take advantage.
Global sovereigns: Will they, won’t they?
In the traditional formula of the romantic comedy film, two endearing leads share a connection, but face a series of challenges before they are able to settle down and live happily ever after. The question is always the same: Will they, won’t they?
This is a question that is also preoccupying global sovereign bond investors, who are keeping a close eye on central banks’ next move. As inflation globally moves lower, monetary policymakers should be getting a lot more comfortable with easing the apparent “high” levels of interest rates. But uncertainty still abounds. So: will they cut, or won’t they?
With labour markets still buoyant, the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England – most central banks across the world, in fact – are seemingly becoming increasingly concerned about the strength of labour markets, which may in turn see them hold off on easing too soon.
For example, the minutes from the Fed’s January Federal Open Markets Committee (FOMC) meeting stated most participants “noted the risks of moving too quickly to ease the stance of policy and emphasized the importance of carefully assessing incoming data in judging whether inflation is moving down sustainably to two per cent”.8
It is worth noting that in some economies the levels of wage growth have eased. For example, the recent negotiated wage release numbers from both Germany and France would certainly allow the ECB to breathe a little easier, but clearly more of this kind of data is needed, and not just in Europe.
In Australia, wage growth is back to historically high levels not seen in close to 15 years; in the UK, the unemployment rate remains at an almost all-time low of 3.8 per cent (see Figures 3 and 4).
Similarly, the unemployment rate has barely moved up in the US, Germany, France, Canada, Australia or New Zealand, to name but a few. Yes, we have moved off from the lower bound in some economies but not to any vast degree, and seemingly not yet to levels that would really loosen labour markets.
Figure 3: UK unemployment rate (per cent)
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Source: Aviva Investors, Bloomberg. Data as of December 29, 2023.
Figure 4: Australia year-on-year wage growth (per cent)
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Note: Australia wage growth is represented by the Australia Wage Cost Hourly Rates of Pay Ex Bonuses YoY SA Index (AUWCYSA).
Source: Aviva Investors, Bloomberg. Data as of December 31, 2023.
There is a widespread market expectation that interest rates will come down and central banks will reduce or even end their quantitative tightening (or bond selling) operations. But when considering the tightness of labour markets, to what extent can central banks actually ease monetary policy? Reducing rates from their current levels too early runs the risk of reigniting inflation due to elevated demand.
What does all this mean for the way we structure our sovereign bond portfolios? Well, it certainly means that we are somewhat more cautious on duration positioning right now. Coming into the year, the market was pricing close to 160bps of cuts in the US, Europe and the UK for 2024.9 Expectations have been revised and could well shift again. For now, much like central bankers themselves, we remain patient and cautious, with our eyes set firmly on the data. All the while, however, sovereign fixed income remains attractive.
Investment-grade credit: Squaring the climate circle
This month, the investment-grade credit team has been pondering two key issues: first, how investors are likely to assess the relative merits of active and passive strategies when high returns are still available on cash, and, second, the most effective ways to invest sustainably.
These two issues are connected. As investors move out of cash into fixed-income strategies, they will often select a passively managed fund as a first step. Generally speaking, global indices have a higher carbon intensity and worse MSCI environmental, social and governance (ESG) scores than actively managed funds. (Not to mention the inability of passive funds to harness such things as a new issue premium or to avoid the more expensive parts of the secondary market.) But in many cases, investors who are reluctant to invest in an actively managed fund still want their capital invested sustainably.
Paris-aligned Benchmarks (PAB), exchange-traded funds (ETF) or passive funds are seen by some as a way to square this circle. It is argued PABs offer a way to align investments with a world where temperature rises are limited to 1.5°C, as envisaged by the Paris Agreement. But we believe there are some drawbacks with this approach.
For instance, Paris-aligned portfolios tend to reallocate capital to low-impact sectors to achieve the target rate of decarbonisation; this means companies in polluting sectors – even those already taking positive steps to reduce emissions – are not being incentivised to transition to greener operations. And this focus on low-carbon firms further leads to a decoupling of benchmarks from the “real” economy, preventing true progress to a 1.5°C world and limiting opportunities to support the transition efforts of companies whose products and services will be vital on the journey to a lower-carbon future. (Achieving all-economy Paris alignment in portfolios is possible, but requires a sophisticated approach if it is to avoid unintended consequences, such as investment in assets that risk being “stranded”.)
So what does “good” climate management in fixed income look like? We think it is better to engage with companies that are committed to making the changes necessary to align with the transition than to focus entirely on low-carbon firms. Setting Science-based Targets (SBTs) for emissions reductions, as validated by the Science-based Targets initiative, is a good measure of companies’ commitments on this score.
In engaging with bigger companies and encouraging the setting of SBTs, active investors can help contribute to a culture of positive change among firms (as well as avoiding companies that lack a commitment to such change, and which are at risk of becoming stranded during the transition as a result). That’s not to say such an approach does not involve its own trade-offs – but in our view it is more likely to make a positive difference on climate than investing via PABs and is therefore a better way of trying to square the climate circle.
References
- “India’s inclusion in bond index positive at the margin for financing flexibility”, Fitch Ratings, September 27, 2023.
- “World economic outlook”, International Monetary Fund, January 2024.
- “Bond Voyage: A journey into fixed income”, Aviva Investors, November 10, 2023.
- Bloomberg, February 23, 2024.
- “Bond Voyage: A journey into fixed income”, Aviva Investors, December 12, 2023.
- Bloomberg, February 23, 2024.
- Bloomberg, February 23, 2024.
- “Minutes of the Federal Open Market Committee”, FOMC, January 30-31, 2024.
- Bloomberg. Data as of January 2, 2024.
