New Year, New Resolutions

Happy new year and a warm welcome to Bond Voyage, our newsletter 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.

Read this article to understand:

• The disinflation trends that may lead central banks to ease policy
• How a series of global elections could affect EMD
• Why high-yield investors are expecting an uptick in issuance
• Our investment-grade credit team’s realistic resolutions

Global sovereigns: Should old inflation be forgot?

At the Federal Reserve’s December meeting, Chair Jerome Powell delivered a jolt of festive cheer to markets by suggesting an openness to earlier-than-expected interest rate cuts. This “Powell Pivot” caught many by surprise. The Fed was behind the curve when raising rates on the way up; perhaps it has made a new year resolution to get ahead of the cutting cycle on the way down?

"Inducing recession is not a policy goal, and progress on disinflation allows the Fed some room for manoeuvre"

We think this apparent willingness to ease policy makes perfect sense. Inducing recession is not a policy goal, and progress on disinflation allows the Fed some room for manoeuvre. To understand why, we need to look at the right data.

Those who rely on year-on-year inflation figures risk paying too much attention to the ghost of inflation past; by contrast, looking at six-month annualised measures provides a more up-to-date picture. In the US, the six-month annualised core personal consumption expenditures (PCE) price index was below target at 1.9 per cent as of November 30. In Europe, six-month annualised core inflation was below one per cent on this date. Even in the UK, where only a few months ago markets feared a wage-price spiral, six-month annualised core CPI was below three per cent (see Figure 1).[i]

Figure 1: Six-month annualised CPI in selected economies

We understand why the European Central Bank and Bank of England might be hesitant to prematurely celebrate victory over inflation with new year champagne and fireworks. But the holiday period always allows room for reflection and monetary policymakers should now be able to take more comfort from the progress they have made in tackling rising prices. With that, 2024 can be a new start – should old inflation be forgot.

Emerging markets: Year of decision

The key to running a successful fund is to treat each new day – not to mention week, month and quarter – as a new year, a chance to grab fresh opportunities and reflect on past mistakes. It wouldn’t make much sense to wait until January to fix a strategy that isn’t working.

However, there is something about the turn of the year that does prompt one to reflect on what comes next. Here are some common new year resolutions that are likely to be reflected in developments across the EM universe in 2024.

More money: EM corporates and sovereigns will likely be looking to raise cash quickly in the new year, taking advantage of spreads that are around the lows of the past five years and an impressive rally in US Treasuries. Gross issuance for 2024 among EM governments and companies is expected to be roughly in line with 2023, at around $140 billion, although net issuance is set to be only 60 per cent of last year’s $77 billion figure (due to a significant increase in amortisation).[ii] However, if the market remains in its current sweet spot we could yet see more issuance than projected, particularly in the high-yield space, which has been closed for much of the past four years.?

"140$bn expected gross issuance for 2024 among EM governments and companies"

New job: Around three quarters of all people living in democracies will be voting in 2024 (see Figure 2). While the US presidential election is likely to be the most hotly contested of the lot, a number of EM countries are also holding elections – the most ever in a single year, in fact. We don’t see any of these votes as being materially market moving, however. After the political action in Argentina, Turkey, Poland and other countries in 2023, 2024 should feel less eventful, although one always needs to be alert to potential surprises. EM being EM, these could well materialise.

For an election to have a large market impact usually requires a contest between one market-friendly and one market-unfriendly candidate. The election must also usually be a presidential or general election (rather than a local election). The majority of EM elections in 2024 do not fit these criteria: some of the more important ones, like Mexico, do not have a sufficiently negative, or market-unfriendly, candidate running; others, like Brazil, are municipal polls. Of the rest, the South African elections are the ones to watch. While we believe the ruling African National Congress will remain the majority party, it may need to cosy up with a market-unfriendly partner to secure 50 per cent of seats in parliament, although this is not our base case.

New adventures: If 2023 turned out to be the year of distressed hard-currency debt, we suspect 2024 will be the year of local frontier debt. Local-currency debt from Egypt, Nigeria and Turkey could start to look interesting very shortly. For these trades to work, we need flows to return to the asset class, a broadly stable macro backdrop and continued sensible domestic policies in these nations, which should start to combine to reduce the fear of further FX weakness.?

"Local-currency debt from Egypt, Nigeria and Turkey could start to look interesting"

Resilience was the name of the game in 2023, which was perhaps surprising given the multiple crises, big and small, that rocked the global economy. The war in Ukraine ground on, a new conflict between Israel and Hamas started in the Middle East, US/China tensions continued, El Ni?o struck and several banks failed in developed markets. Throughout, EM (and broader markets) have proven largely robust. Will this remain the case in 2024? As ever, the EMD team will offer our take on the latest developments in Bond Voyage.

Figure 2: 2024 elections around the world

High yield: Not-so-dry January

Being a global high-yield team, we like to explore different traditions from around the world at this time of year. In Scotland, for example, “Hogmanay” is celebrated by burning sticks to ward off evil spirits; in Italy, old furniture is left in the street as a sign of renewal; and in Japan, bells are rung at the strike of midnight to symbolise a new beginning.

Many market participants anticipate renewal and rejuvenation in 2024, ourselves included. The auguries are good, with high yield entering the new year on the back of a strong 2023, especially in the lower-rated part of the market. Like many people at this time of year, the team have committed to a few common resolutions that echo likely developments in the market in 2024:

Do more exercise: Given increased or “higher-for-longer” rates, we expect an uptick in the use of Liability Management Exercises (LME) to reduce corporate issuers' overall debt levels.?In all markets, but especially in the US, LMEs are used by companies ahead of debt maturities to reduce or manage their overall debt burden by way of tender offers (or debt buybacks) and exchange offers, allowing creditors to exchange their existing instruments for those with longer-dated maturities and/or otherwise amended terms.

Eat Healthier: As for the health of the high-yield market, it looks slightly less robust following several years of “rising star” activity, which has seen the strongest, fittest issuers migrate back to investment grade.?Nevertheless, companies in the high-yield universe now tend to be larger than in the past (with a combined EBITDA many times bigger than before the Global Financial Crisis) and CCC-rated debt now comprises a much lower proportion of the overall market.

Read more: While defaults should remain in check, the importance of understanding covenants should not be overlooked in 2024. (We expect several former Credit Suisse AT1 holders will stick to this particular resolution.)

Not-so-dry January: Many people look to compensate for holiday indulgences with an abstemious start to the year, but in this respect high yield is bucking the trend with a potential jamboree of new debt. The recent rates rally, paired with the strength of equities markets, puts high yield in a “sweet spot” and we anticipate strong new issuance in January.

Investment-grade credit: Realistic resolutions

Most people who make a new year resolution fail to keep it. The key to sticking to resolutions is all about being realistic on the goal and the outcome. Whilst we on the investment-grade credit team would love to be Olympic-standard athletes by the end of 2024, we recognise we are probably not going to get there.

From an investment perspective, we enter 2024 with a cautious outlook. And, as with all those resolving to make changes as the Christmas decorations come down, remaining realistic will be key to success. We know spreads are already tight following the Powell Pivot in December, and rates will probably fall provided?inflation behaves. So, realistically, where is return in investment grade going to come from this year? Here are some salient points:

Carry: “Carry” is a term used by fund managers to describe the interest that comes into a fund from owning bonds that pay coupons. The steeper the credit curve, the higher coupons will be; our aim is to harness the optimal carry given the shape of each curve. On average, coupons paid on bonds are now significantly higher than they have been over the past decade; when coupons are paid into investment-grade funds, the manager therefore has a lot more cash to reinvest. As this must be reinvested back into investment-grade bonds, the outcome is sticky demand.

"Coupons paid on bonds are now significantly higher than they have been over the past decade"

Demand: Over the last 12 months, money market funds have been attractive in comparison to investment-grade credit, due to higher risk-free rates, which means the flood of investment into the market we imagined back at the start of 2023 has not materialised. However, as the front-end yield has come down, investors have been increasingly turning to duration and investment-grade credit. Spreads have already materially tightened as a result. Increased investment into the credit market provides support for prices; absent anything else, it generates positive structural support from inflows and positive structural support from higher coupons. Essentially, the longer these higher coupons are being brought into funds, the more cash the funds generate each time there is a payment – compare 1.5 per cent in 2019 and 2021 vs six per cent now. [iii]

Supply: The expected increase in LME provides further, technical support for investment-grade credit. Some corporates that are laden with cash as the result of rate moves have chosen to strengthen their balance sheets with buybacks of their bonds. In most cases, this debt has traded well below par, with the issuer buying it back for a higher price (but still below par), meaning investors receive a decent premium and the corporate books a capital gain on its own balance sheet. The consequence is a reduction in supply and increased demand, providing further price support.

"The market has become more comfortable with rates volatility, and higher rates provide more of a cushion"

Whilst we appreciate spreads will likely be more volatile over 2024, the market has become more comfortable with rates volatility, and higher rates provide more of a cushion; in this context, the structural support for investment grade provides an additional benefit. Therefore, we will concentrate on harnessing the optimal carry and, with the help of our analysts, identify corporates from which supply is likely to decrease going forward.

We will also continue to select bonds of a high quality where possible, cognisant there will likely be some bumps in the road despite the positive trends outlined above. Our resolution, then, is to stay vigilant and keep an eye on realistic outcomes. And unlike those whose commitment to running a marathon or penning a novel lapses at the start of February, we aim to keep it throughout 2024.

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Investment Risk

The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.

Credit and Interest Rate Risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.

[i] Bloomberg, as at November 30, 2023.

[ii] JP Morgan, as of December 31, 2023.

[iii] Bloomberg, as of December 31, 2023.

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