The Corridor of Uncertainty

Climate change, Covid-19, supply chain issues and inflation are just a few of the problems facing the global economy today. No wonder policymakers and investors find themselves in a corridor of uncertainty.

In episode 5 of our Fixed Income TEAMTALK podcast, Amit Moudgil is joined by James Athey, Luke Hickmore and Siddharth Dahiya for a discussion about the choices facing central banks and the opportunities for fixed income investors.  Visit us for previous episode

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Transcript

The Fixed Income TEAMTALK talk by abrdn  

The Corridor of Uncertainty

Amit Moudgil: Welcome to this edition of the abrdn Fixed Income TEAMTALK. My name is Amit Moudgil, Fixed Income Investment Specialist at Abrdn, and I'm your host today. Today's TEAMTALK is entitled the Corridor of Uncertainty, given the recent news on inflation, supply chain problems, climate awareness and related issues and generally the problems faced by policymakers when it comes to balancing economic growth and decisions over the next step in terms of policy. 

So to tackle this topic, I'm delighted to be joined by James Athey, an Investment Director in our Government Bond Team, Luke Hickmore, an Investment Director in our Corporate Bond Team, and Siddharth Dahiya, Head of Emerging Market Corporate Debt.

Okay, so before we get into the meat of the discussion, a feature we have on the podcast is called “What's your favourite?” That is to allow our listeners to get to know our speakers a little bit better. So, given the recent release of the new James Bond film, No Time to Die, I thought it'd be a good “What's your favourite?” to find out who their favourite Bond is or what their favourite Bond film is, and why. So I'll go first. So for me, James Bond was Roger Moore growing up, but I really like Daniel Craig's first outing as Bond which was back in 2006, in the film Casino Royale. But what I really liked was actually his portrayal and Bond was more kind of gritty and hard-hitting, a bit more robust than the kind of suave and sophisticated Bonds we'd seen before, but also quite liked the poker  scene as well, and in particular, the line “I'm sorry, that last hand nearly killed me” which was quite good. And now over to you, James Athey.

James Athey: So I like you grew up with Sir Roger Moore but unlike you, I'm going to stick with Rog as the purveyor of the finest Bond movies so it's very close between The Spy Who Loved Me and The Man with the Golden Gun, but just pipping it, possibly because of the theme song. But also, you know the storyline sort of one armed man, crocodiles, and running across crocodiles’ heads, the winner for me is Live and Let Die and that must also give a special mention to Sheriff JW Pepper who was such an excellent additional character that he then subsequently made an appearance in another Bond film shortly afterwards. Roger brings suave and sophistication as you say, but there's also a little bit of comedy in those 70s and 80s Bond movies so Live and Let Die is my favourite. 

Amit Moudgil: That's great. I thought we were about to get a rendition of the theme song there but we'll maybe leave that for next time. 

James Athey: I can give you the Guns and Roses version as well.

Amit Moudgil: That would be good. Well, we'd love for them for next time, James. Over to you Luke, what's your - favourite Bond film? Why?

Luke Hickmore: Well, there's only one Bond and it's Sean Connery. You would maybe need to be of a certain age to appreciate that and if it's Sean Connery there's really only one Bond film that wins at the top of any list and that's Goldfinger and for no other reason than it's when he first said “a martini shaken not stirred” and Bond came out as what he was at the time. You know, everything good and everything bad in today's eyes about Bond was in that film. Absolute classic. If I had to pick a more recent one I’d go with you as well Amit, by the way.  Casino Royale needed to be remade the original was so poor, but no, Goldfinger for my all-time best.

Amit Moudgil: Thanks Luke. As Bond says, a  Martini shaken not stirred is your drink but ill maybe pick that up offline for you mate. And Sid, what about you? What's your favourite Bond? 

Siddharth Dahiya: Well, I love Bond movies because I can totally relate to the guy, right? But jokes aside I mean I to be honest, I'm not a massive fan of Bond movies, and maybe the older movies. To be honest, I've not even seen all of them. Daniel Craig seems alright. And as a Bond, he seems to be not overly perfect. More human. I suppose. As you've mentioned, I'm going to go for a one of the newer ones. So I would go for Skyfall mainly because actually, because of Javier Bardem, who was in the movie who's one of my favourite actors.  

Amit Moudgil:  Yes and Skyfall obviously was set in Scotland. So yeah excellent choice all round so thank you guys. So, to our listeners, what's your favourite? Hope you enjoyed that, and now on to the discussion and I guess we're best to start but from the kind of macroeconomic perspective. 

So James, can you give us a brief overview of the rates or government bond outlook across the kind of major markets? 

James Athey: Yeah, sure thing Amit, brevity is quite difficult in a scenario so unbelievably complex and volatile, febrile, uncertain and - loath to use the word unprecedented, but to some degree, it is at least in in the last 30 or 40 years. Huge amounts of uncertainty. The outlook is, for that reason, therefore, quite uncertain, we're seeing a huge amount of inflation pressures, which we still believe will ultimately prove to be transitory, but they are lingering longer than some had suspected. And certainly the magnitude of price changes is much greater than the market had been expecting 6 or 12 months ago. So inflation obviously as a general rule isn't good for bondholders, it erodes the real value of those fixed coupons. But the extent to which it's truly destabilising does depend to some degree on the central bank response that will impact how far yields rise and indeed how the curve shape changes. And it gets a bit more nuanced in that regard. I do think we have seen in the last few months, however, increasing evidence that the likes of the Bank of England and the Federal Reserve are being pushed, shall we say towards a more hawkish stance that's going to involve both balance sheet and rate policy in the coming months. We expect that to lead to flattening pressure in those yield curves, the European Central Bank (ECB) as always a bit of a special case, the eurozone remains a much less healthy economic region with much greater structural impediments to growth going forward, and the ECB remains trapped in terms of its policy stance because of the potential for a volatile and destabilising repricing of peripheral yields and spreads. And so while we think the ECB will again be forced to wind down some of its pandemic, emergency asset purchase programmes, they will try and increase some of their standard purchase programmes to offset, we certainly don't think the ECB will be in a place to hike rates as far as the eye can see. So maybe steeper curves in Europe relative to the US and the UK where we expect curves increasingly to flatten. Broadly speaking, we don't think yields can rise too far. However, we remain in a highly indebted global situation. And we would characterise the underlying economies as still suffering from long term structural health issues and imbalances which act as a headwind to growth and really do limit the extent to which central banks can be too aggressive with policy removal. 

Amit Moudgil:  Excellent. And I guess, I kind of alluded to in the in the brief intro, there's an increase in the importance of environmental, social and governance (ESG) considerations. And I guess more recently more on sort of climate in particular, but how important are these considerations when it comes to the bond market? Sorry, government bond market? 

James Athey: Sure thing. Yeah, so ESG, obviously, is a set of risk factors, which are expected to impact the return on assets. You know, that's how we think about ESG when we're doing credit analysis or Equity Analysis within the firm. The idea behind that is that companies that don't manage those risks well would be expected to underperform in the long term. Therefore, it aligns the interests of investors like ourselves, shareholders and the company itself to have policies to deal with the challenges that might be presented by environmental issues to ensure there’s good governance of  the firm itself, and to ensure that the responsible relationship between the company and society at large, therefore the analysis, taking into account those factors, it's all pointing in the same direction doing a good job around ESG analysis will help us identify companies that will outperform over the longer term. In government bonds basically it is slightly different because the way in which government bond yields move tends to be in the opposite direction to economic activity. And for example, if we were to take environmental issues such as flood risk for a low-lying country like the Netherlands, it's not necessarily the case that the return on an investment in a Dutch government bond would necessarily be adversely affected by the fact that the Netherlands is a low-lying country with flood risk. Again, yields tend to fall, which means prices rise when the economy is doing less well. And that would be what we would expect if there were to be a major flood in the Netherlands. 

Notwithstanding, we would argue that many of the factors that we would consider within ESG would have would have been and were part of our sort of standard analysis for sovereigns for looking at the state of affairs within a country and the likely path of, of interest rates and inflation, for example, societal issues, political issues, very much within the S and G aspect. E, as I say, presents some  slightly different issues. But absolutely working with our own internal research teams, you know, that's fully integrated into our research process, just to ensure that even if we conclude that these factors are not likely to significantly affect future returns from those assets, we have gone to, to the effort of fully considering those when we're making an investment decision. 

Amit Moudgil:  Is there anything that the abrdn Government Bond Team are doing to tap into the climate theme?

James Athey: Yeah, so obviously, green bonds are becoming a hot topic, if you like, they've been around for quite some time in the corporate bond space, in some of the sort of  supranational issuers and increasingly we’re seeing green bonds being issued in government bond space, we actually think we can do better than that green bonds really is a label, it's a use of proceeds. It's a declaration of intent. If you like from the issuer, there aren't a huge amount of standards across the piece just yet. That's coming with time. But realistically, that money is  absorbed into central financing. It's not directly linked to projects of a quote unquote, green nature. So we're working on a product as it stands whereby we've worked with our internal research team or ASIRI to create a framework that doesn't just analyse the intentions of governments. But it analyses the state of affairs with respect to carbon emissions, the trend with respect to carbon emissions and puts a significant weight on the policy setting across a number of dimensions. Therefore, we believe that this framework actually helps us to identify countries who not necessarily start from an advantageous position with respect to carbon emissions, but countries which are on the right path. And therefore we can tilt investments within a portfolio to favour those that we believe are on a more virtuous path with respect to managing environmental issues, you know, both within their borders, and obviously, globally, as well. So putting together a product that will have this additional analysis, this additional scoring with respect to environmental issues as an overlay on top of our usual investment process, managing interest rate risk, that's something which is in the pipeline at the moment, we don't see many competitors out there and government bond space who have similar products. It's something we're pretty excited about.

Amit Moudgil:  Thanks, James. And I want to come to Luke to get the perspective from our corporate bond side of things. Luke, is there anything or any area within corporate bonds that you look at that is particularly appealing right now? 

Luke Hickmore: Yes, I think so. If  we accept, as James was talking earlier on that we are not going to be seeing runaway inflation forever, and yields heading to the moon, I think credit ends up being quite a stable part of a client's asset choices. So we've seen very little volatility of investment grade bonds in particular over this year, and that seems likely to continue. So with that, as a background, it does feel worthwhile extending out into some of the riskier parts of credit. So that's the better end of high yield and the double B and single B space. And it's into emerging markets for us as well, which we do for funds which can and also into some of the subordinated areas of bank capital, where we've been able to find some great value over the last couple of years in the AT1 – the so-called AT1 space for bonds where, you know, you're still able to get returns of three, four, maybe even 500 basis points of spread, which when you consider your average investment grade index is around about 100 basis points of spread. And that's a really nice additional yield for clients when we are in this broadly stable, technical background for credit markets.

Amit Moudgil:  What about areas that you think you're a bit wary places in the market, the corporate bond space that you think you're just, you're maybe holding back from?

Luke Hickmore: Yeah, for sure. So when we're thinking about, you know, maybe moving into defensive areas you would have thought about utilities in the past and this is becoming an area of land mines. We've seen Scottish and Southern recently have attached to them with private equity risks, we're seeing increasing exposure to the corporate bond market with ESG risks, environmental risks in particular. So along with many other investors we don't invest in gas past 10 years, because we know home heating is going to change over that time timeframe, or at least the government's aiming to change that timeframe. And it makes it really hard for these companies to think about how they change between here and then. And actually, the broad swathe of investment grade which is less than 100 basis points of spread really gets difficult for us to find good ideas in without being concerned that actually you're just exposing yourself to the risk of a company at its best, rather than actually one that could be improving that you could actually make some money for a client from. 

Amit Moudgil:  And what about valuations now Luke, within the corporate bond space, are there areas that you think are better valued across the market, what are you seeing right now?

Luke Hickmore: We've had a really good, I suppose, eight months, using bonds that are coming out of lockdown, coming out of COVID that were really hit last year, but that's largely played its way out, there are a few areas left in there, maybe, but largely played out. I think the airports in the UK are still offering great value at around 80 basis points of spread. We've got theme parks, in funds, which we think are actually still offering good value and around a four and a half percent yield. And that's both people like Merlin in Europe, in the UK that do Alton Towers, etc. But we've also got Six Flags and a company called Fun in the US, again, all theme park-related. And that little part of the portfolio I think is great value at the moment, as we'll see, you know, consumers start booking up for next spring as the world opens up again, and they're still, you know, really good quality underlying businesses. And I guess those are the things that we prefer the most at the moment is that fundamental excellence that we're looking for, from our investment grade portfolios and the fundamental improvements that we're looking for, from high yield and EM and all of them with enough of a spread to make it worthwhile but as I said tends to be over 100 basis points. And you know, even in in some of our more flexible funds where around 54% of the funds has got over 200 basis points of spread on each bond. So those are the areas I think you can still get good enough carry, good enough returns to make it worthwhile investing in credit. 

Amit Moudgil:  And Sid,  from an emerging market corporate bond angle, I guess the first question I'd probably ask is should  clients be worried about investing in emerging market corporates? 

Siddharth Dahiya: Yeah, thanks Amit. Investing in EM can often seem fairly daunting because of the way news works you know, bad news travels a lot faster and a lot further than good news and there's plenty of bad news to be found if you cover more than 70 odd developing countries but the real truth of the matter is that you know in EM corporate particularly in the dollar space, in the hard currency space  have a long history of strong performance over market cycles you know. In our own experience corporate dollar bonds tend to be the most defensive part of  EM Fixed Income now, this is sort of becoming more and more of a market consensus view you know, only a few years ago, people used to look at EM corporates as a bit less defensive, a bit more volatile. The reality is that this is a very diversified asset class with good credit quality offers a lot of diversification has fairly low interest rate risk, you know, duration for this market is fairly low at less than five years. And over the last 10 years, in particular, over the last five years, the Sharpe ratios in the EM corporate space have been one of the best across various risk markets within Fixed Income. 

Amit Moudgil:  I guess what clients would then ask is, what is the trend in default rates looking like for EM corporates right now? I'm going to guess it's on a downward trend, but could you give us a little bit about the history of default rates generally, how that is going to look?

Siddharth Dahiya: Yeah, default rates been fairly benign. I mean, I think, as Luke mentioned, from his asset class default rates have been generally benign posts - COVID at least a lot less than people expected them to be. And default rates were about just over 1% last year for EM corporates, which is a fairly low number, you're definitely being compensated for taking that kind of default risk. And I think one of the things that we need to remember about EM corporates is that credit markets in general have been the beneficiary of quantitative easing (QE), across the world, excessively loose monetary policy. And EM companies have also definitely benefited from that in the sense that their funding costs have gone down. 

But one thing we have observed over the last few years is that EM companies have actually not taken on a huge amount of debt. Yes, EM total issuance from EM dollar bonds has increased over the last few years. But that's because more and more companies are choosing to issue in the dollar space globally. But if you look at leverage numbers, debt to EBITDA, numbers, for example, actually, despite COVID over the last few years, EM corporate debt to EBITDA, leverage numbers have been going down. So much so that, you know, some of the forecasts say that at the end of this year, or the end of the first half of 2022 the overall leverage in EM corporates is going to be the lowest it's been since 2011. So the lowest it's been in a decade. So EM companies, actually their credit profile, the  underlying balance sheets have improved tremendously. Now I think if you compare that to companies in the developed world, so US companies, US investment grade, as well as high yield companies, for example. I mean, their leverage has shot up significantly post-COVID. Some of it is because of a drop in earnings. But a lot of it is because companies have taken on excessive debt or what we call unproductive use of funds, i.e. giving money back to shareholders, which obviously as bond investors we don't like. 

Companies in the US have done a lot of share buybacks, tender activities, you know, M&A, especially dividends etc. and companies in EM have really shied away from all of that. Also the money that EM companies have raised is basically for refinancing, all for investing in themselves for future growth.

Amit Moudgil:  Is there a  stark difference between the valuation of investment grade and high yield within that space, which part of the market are you favoring right now?

Siddharth Dahiya: Yes, there is a difference between investment grade and high yield, but you know, there are attractive portions in both parts of the market I mean, there are a few spots in the investment grade space which look really attractive. There are a few more opportunities in the high yield space, you know, as a house, we tend to have fairly large teams, we are able to look at every pretty much every name that comes to our markets from the corporate space. 

And generally, we tend to find a little bit more information asymmetry in the high yield space, we tend to favor high yield, the spread of high yield over investment grade is quite attractive at the moment. Admittedly, you know, the goings on in the China high yield space is causing some of that spread elevation. But if you exclude China high yield, then EM high yield looks quite attractive. And actually, if you compare EM IG to US IG, for example, the spread pickup is anywhere between 70 to 100 basis points, whereas in the high yield space it’s actually more than that. So a lot more attractive. And you have to keep in mind that, you know, within the last five years, there have been times where EM high yield has traded through US high yield. So, at the moment, you are being paid very well for taking the risks in EM.

Amit Moudgil:  That's great. Thank you, Sid. So I think that's probably all the time we have so before we close, I'd like to say thank you to all our speakers today. Thank you guys. And thank you to everyone tuning in today. And so as just a final thought, maybe not quite in the James Bond style, but given the thoughts of James, Luke and Sid, the corridor may not necessarily be as uncertain as we first thought. But we'll see you next time. Thank you.

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