In a land of opportunities… select carefully

“Compound interest is the eighth wonder of the world”, said Albert Einstein. Over the past decade, Fixed Income investors weren’t able to fully experience this wonder, as historically low and even negative yields obscured the power of compounding.

Fortunately, since mid-2022, yields have roared back, firmly establishing rates in positive territory, and providing investors with a multi-decade opportunity and enticing entry points. Global sovereigns and corporate bonds offer yields last seen in 2011. 

However, to truly benefit, investors will have to keep their eyes open. While external concerns have diminished, specific and idiosyncratic risks are gaining prominence across Fixed Income asset classes.

Opportunities aplenty?

Money Markets yields approaching 4%[1] now make cash-parking attractive, allowing investors time to search for investment opportunities. Investors can also invest in this low-risk asset class to manage volatility of their bond portfolios.

Euro Investment Grade credit now allows investors to lock in very interesting yields of 4.3%[2] or more, with an extraordinarily flat maturity curve. Investors can lock in historic levels of yield over a longer period in a relatively high-quality asset class, as equity markets settle back into their more traditional role of lower dividend yields and higher volatility.

Global High Yield markets are also presenting a very different scenario, with attractive coupons above 8%[3], versus barely 4% two years ago. And the quality of the High Yield market has improved significantly since these rates were last seen, in 2011 (with Euro HY[4] now composed of 75% BBs, vs only 50% in 2011, and US HY[5] now composed of 50% vs 35%). The higher-quality Global High Yield BB rated portion now yields well above 5%.

Government bonds stand out. Investors are unlikely to forget that almost the entire German sovereign curve was negative a mere two years ago. The short end of the European safe-haven now delivers roughly 3.6%[6], while its US counterpart is at a whopping 5.3%[7], offering low spread risk and no credit risk.   

Emerging sovereign debt is leading the way with coupons over 8.7%[8]. A non-negligible portion of the market consists of potentially undervalued debt restructuring stories (countries closing in on agreements with creditors), and which we estimate to have a yield of over 12% on average.

Risks: From Macro to Micro.

While Fixed Income Markets feel particularly welcoming, we believe it will be essential to identify idiosyncratic risks. Yields may be back, but bond returns remain asymmetric. In the absence of central bank support, market values of corporate and sovereign issues are once again dependent on fundamentals. Bond markets which were recently driven by central banks are now more influenced by economic data, balance sheets and business models. Adding to this is the ever-growing importance of Environmental, Social, and Governance factors to credit risk.

Corporates are entering an environment in which the cost of debt service has increased considerably. Incidentally, we believe that current spread levels in Euro Investment grade (145 bps2) and Global high yield (420 bps3) fail to accurately reflect these risks. Within the high yield segment, we also expect spreads to widen around 500 bps (though with considerable volatility in 2024) and default rates to climb moderately to over 5%.

Digitalisation, automatization and artificial intelligence trends have a strong influence on business activities. Issuer ability to adapt will be vital. It seems obvious that large companies with highly-diversified businesses that are not geared towards the end-market consumer are much less exposed to economic slowdown. The new environment favours companies with low leverage and visible cash flows. Certain issuers will be more sensitive to repayment schedules, and under pressure to re-finance at higher rates. While the Investment Grade segment as a whole is unlikely to be impacted by a “maturity wall”, the high yield space could face a refinancing hurdle in 2025 and 2026. 

Similarly, Sovereign issuers will increasingly be dependent on their economic and debt profiles, and specific risks will also be key in this sector. Fiscal policies and political risks will return to the forefront. Indeed, markets are paying greater attention to  budgets, and to the impact of higher rates on debt sustainability. In the past, the distinction was primarily between core and peripheral markets, but we expect a very different future. Just take a look at the example of Portugal -- following its fiscal reforms, its bonds now trade at lower spreads than those for France. We also expect material volatility in a year where several large nations will be heading to the polls, with general elections in the US, UK, India, Indonesia.

A rising number of emerging nations will surely require assistance from the IMF, which is likely to base its help on fundamentals and political will. Some countries, such as Ghana, Zambia and Sri Lanka are well along in their restructuring, while other distressed countries are not.

Sustainability metrics now essential in assessing sovereign creditworthiness, as climate change is having a material impact economies. For example, India, a strong growth story, nevertheless faces an impact from pollution. Schools and public institutions were recently closed for several days in certain cities, and long term health impacts are already apparent. These elements will affect the overall debt profile of a country over the long run.

Investing: Make Haste…. Slowly

Fixed Income markets now offer a plethora of yield opportunities. The importance of carry in bonds is not just income, but also the strong cushion it provides against adverse market conditions. In case spreads widen for a particular fixed income segment, the carry can protect investors by partially offsetting the drop in market value. The new interest rate landscape – or shall we say, the return of a normal interest rate landscape – favours a diversified fixed income allocation, with each segment  both providing income and fulfilling a specific role in the portfolio.

To exploit these opportunities, investors must understand and analyse the risks that surround individual issuers. This bond-picker’s market demands a careful selection of issuers and issues to achieve risk-adjusted returns. Rigorous and disciplined bottom-up research will be, more than ever, needed for both sovereign and corporate issuers, to gauge creditworthiness and understand the risks specific to each issue.

Incorporating ESG analysis across fixed income markets is a prerequisite to develop a full understanding of debt sustainability, which will be a vital part of bond portfolios in the future.

Einstein’s observation continued, “compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn't – pays it…

[1] €ster: 3.902% as at 24.11.2023 – Source: Bloomberg
[2] ICE BofA Euro Corporate Index as at 24.11.2023 – Source: Bloomberg
[3] ICE BofA Global High Yield Index as at 24.11.2023 – Source: Bloomberg
[4] ICE BofA Euro High Yield Index as at 24.11.2023 – Source: Bloomberg
[5] ICE BofA US High Yield Index as at 24.11.2023 – Source: Bloomberg
[6] German 12 month rate, as at 24.11.2023 – Source: Bloomberg
[7] US 12 month rate as at 24.11.2023 – Source: Bloomberg
[8] JPM EMBI Global Diversified Index as at 24.11.2023 – Source: Bloomberg

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