Government and inflation-linked bonds
An accelerating economic recovery, encompassing more regions and underpinned by fiscal and monetary stimulus, was one of the main narratives in markets during Q2. This changed abruptly in early July as yields on 10-year US Treasury paper hit a four-month low. Growth momentum, along with inflation, have become the key debates.
Monthly consumer price index (CPI) prints have significantly exceeded expectations, although a substantial part of the overshoot in inflation comes from rising energy prices and one-off supply-demand mismatches in sectors like travel, hotels and used cars. Looking at recent CPI history suggests a reversion to trend rather than a breakout in inflation. However, ongoing bottlenecks and hiring difficulties raise the possibility inflation could prove higher and more persistent than expected.
Despite the significant upward revision of its 2021 inflation forecast, the Federal Open Market Committee (FOMC) remains patient and continues to expect inflation to fall next year. The Fed is likely to continue to semaphore the eventual tapering of asset purchases, thereby avoiding a replay of the 2013 taper tantrum. However, a less accommodative policy stance is expected to contribute to a consolidation in inflation expectations, while real yields should drift higher.
The European Central Bank has increased its growth projections and raised inflation forecasts, but confirmed it would continue higher asset purchases while being ready to adapt to keep real yields near record-low levels.
Given the unique situation and unusually volatile economic data, we expect it will be the end of the year before a clean read of the economic situation is possible, although we believe a broad based tightening of the US labour market is unlikely in the near term. Key indicators to monitor are the NFIB hard-to-fill-jobs index and the Employment Cost Index.
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Corporate credit
The credit cycle continues to normalise, with the wave of fallen angels giving way to a growing list of rising stars. However, the picture in emerging markets is mixed and we see under-appreciated risk from vaccine-resistant mutations as the pandemic endures. Wary of the short-term bounce, we are taking profit in Covid-vulnerable sectors.
High demand, low all-in yields, lighter covenants and the opportunity to diversify sources of funding are attracting more companies to the bond markets. Fortunately, businesses remain generally bondholder friendly, with M&A activity limited, excessive levering up avoided and dividends largely kept in check.
The market is now as tight as ever, with spreads below pre-Covid levels and little dispersion, while books remain oversubscribed despite supply being at an all-time high. Capital appreciation is no longer a driver of returns, with better index quality making even high yield more of a carry trade. In this environment we continue to see subordinated bonds and hybrids issued by BBs and selected Bs as the sweet spot for risk-adjusted returns.
The new-issuance premium offers some pockets of value, but well-resourced, bottom-up research is needed to identify strong candidates. Given the dearth of value in the market, the elephant in the room is what happens if positive sentiment turns and liquidity dries up.
Looking ahead, our preference for green and sustainability-linked bonds issued by names with solid liquidity and a clear pathway forward is supported by the increasing focus from central banks on such securities in their asset-purchase schemes.
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Emerging market sovereigns
The stabilisation in emerging market (EM) bonds throughout Q2, which generated strong returns in April and May, gave way to a risk-off trade in early July as yields on US Treasury 10-year debt declined substantially on lower growth expectations. This flight-to-quality move has weighed on EM spreads and FX, widening the overall yield gap between Treasuries and local-currency EM bonds.
Covid remains an issue, and supply bottlenecks and higher food prices have made inflation a concern. But effective action from many EM central bankers and slowing commodity price rises should help keep inflation expectations anchored. Rising sociopolitical risk is a potential issue, given recent government raids of pension funds and lurches to the left in Peru, Chile and Colombia.
Dovish monetary policy in developed markets is driving investors to EM in a hunt for yield, although sentiment remains fragile. Curves remain steep and carry and roll-down is high, supporting returns. With fiscal deficits still high, strong issuance should continue but is likely to be met by healthy local demand. In local-currency markets, improving growth, stronger current accounts and better carry lead us to continue preferring FX over rates.
Overhanging debt remains a key issue for many EM sovereigns, although fiscally prudent countries like Mexico are in a strong position going forward. Overall, we expect the gap between EM and developed market growth to narrow in H2.
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Sustainability
At its June summit, the G7 agreed to move towards mandatory climate-related financial disclosures – another important step forward in the greening of the global economy. We believe the economy is undertaking a profound transformation that will have wide-ranging implications for risk and returns, and have built the CLIC™ (Circular, Lean, Inclusive and Clean) framework to inform our investment strategy accordingly.
Issuance of sustainability bonds in 2021 has been especially strong and is on course to set a new annual record. This is a positive phenomenon, but we recognise the need to not only assess the use of proceeds or conditions attached to the bonds, but to also analyse the companies’ business practices and alignment to the sustainable transition. In our research, we have discovered companies which pass the first test but fall down on the second.
A Latin American meat producer with global operations provides a good example. Its financials appear sound, it has an investment-grade rating, and its sustainability bonds link to KPIs to reduce greenhouse-gas emissions by 30% by 2030 with a coupon step-up in the fifth year if the intermediate target was not met. In an emissions-heavy industry such as this – what we describe as a ‘hard-to-abate’ sector – these targets, tied specifically to a bond, appear positive.
However, despite these attributes, we opted not to participate in the company’s new sustainability-linked bond issue due to broader sustainability and ESG-related issues, and governance concerns at the parent level, that overrode the particular characteristics of the bond.
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Systematic research
Data-driven insights are vital in our holistic approach to portfolio construction. The use of credit convexity as a means of managing tail risk is one example, which is especially pertinent in the wake of the Covid-19 crisis.
Financially, the Covid-19 crisis was unusual in that it saw a sudden loss of liquidity, marked by a dramatic spike in volatility. While overall equity and credit drawdowns were only 60% of the severity of those seen during the 2008 crash, the entire crisis transpired within a month. As a result, volatility levels in equities rivalled historic highs, and in credit were significantly higher.
The extreme rise in implied volatility suggests harnessing positive convexity may be an effective hedge for managing tail risk. Our research finds that credit default swap options (CDSOs) mitigate a sudden liquidity-driven selloff particularly well, since prices tend to be very low in benign periods and spike significantly in times of volatility. However, options-based convexity exposures can become extremely expensive in volatile periods.
Realising this, we have investigated a ‘cost-based’ hedging approach. This involves buying more convexity when spreads and implied volatility (and costs) are low, and less when costs are high. With option costs back at pre-Covid lows, embedding convexity into traditional credit mandates in this way can help defend against tail risk, in our view.
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