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Responsible investing
Looking beyond green labels in emerging markets
It is important to look at impact-aligned bonds that are not labelled as such
Q&A: should ESG funds be going short?
Some issuers are easier to reach out to than others, but engagement remains a valuable tool
HIGH YIELD
European high yield: set to benefit from an improving trajectory?
Valuations are at levels that have historically generated compelling returns, and credit metrics are at a decent starting point
Economic outlook
Opportunities amongst the rubble as we enter 2023
Recent times have been challenging but there is still potential in the credit landscape
Have you got the ‘S’ factor? The rise of ‘social’ in ESG
Investors are increasingly recognising that assessing social factors helps to minimise reputation and regulatory risk
OUTLOOK
Is fixed income now attractively priced for investors to return?
The challenging conditions are not yet over but there is value to be found
Securitised credit
Dislocations in securitised credit are offering potential
There are opportunities for outsized, high quality, risk-adjusted returns
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Progressive fixed income
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Macroeconomics
Where next? Global pain, the UK risk premium and pockets of value
The bond market has been through a tumultuous time recently but what is next?
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Core fixed income
The macro winds have shifted – active management is back
Low yields encouraged the rise of passive investing but there is now significant opportunity for excess return in fixed income
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EM sovereign debt has seen outflows but may turn the tables on frontier markets going forward
A changing narrative: opportunities in emerging markets
EM sovereign debt
Monetary policy and current account levels make a compelling case for allocations
Q&A: Should ESG funds be going short?
BlueBay still believes there is long-term structural demand for sustainable investment practices and will continue to refine its strategy in the coming year
Sustainable investing in 2023
There are strong tailwinds in EM debt
EMERGING MARKETS
Engaging with issuers: your questions answered
HIGH yield
There are opportunities for outsized, high quality, risk-adjusted returnse not labelled as such
The situation is challenging but we would expect credit metrics to remain resilient across the European energy sector
Energy outlook: the heat is on for European markets
Commodities
All eyes are on the Fed but China’s reopening might be more significant
The real pivot? Seven key investment themes for 2023
In the Chinese year of the water rabbit, the outlook for EM is looking more positive
Are the clouds lifting? Positive prospects for EM in 2023
Emerging markets
Investment-grade credit could offer comparable yield to stocks, with less downside risk and volatility
The return of the bond bull: RBC BlueBay’s market outlook
Market outlook
There is a wide range of activity going on in the ESG space, among sovereigns and corporates alike
What ESG trends are we likely to see in emerging markets?
Sustainability
RBC BlueBay considers the likelihood of default across both the sovereign and corporate credit worlds
Will EM default rates increase with higher US interest rates?
The US economy could enter a short and moderate recession while Europe’s downturn could be deeper
Peaks and troughs: RBC BlueBay’s forecast for inflation and growth
Some of the key issues on the agenda for responsible investment as we move forward
Where next for ESG? Seven key trends
The quality of fundamentals and technical factors gives us confidence that global high yield can bounce back quickly
The economic outlook may be uncertain but subordinated debt instruments such as CoCos are well placed
A huge opportunity? The latest in bank subordinated debt
Subordinated debt
Is global high yield set to repeat its strong rebound pattern?
Recent events have brought home the importance of addressing issues around water
Drought? Sewage on beaches? Investing to address recent water challenges
SUSTAINABILITY
Bondholders are using their size to back or withdraw support for issuers
Unlocking the bondholder’s voice: the rise of fixed income engagement
Investors can be optimistic of positive returns across a range of scenarios
Bullish or bearish, investment grade looks well placed to perform
investment grADE
The importance of the blue economy in building a sustainable future
The ‘blue economy’: taking action on our marine and freshwater environment
Stewardship is becoming more recognised in public debt markets
The importance of (pragmatic) investor engagement
Their growth has been positive but we need to improve industry standards
Sustainable finance and the emergence of ESG-labelled bonds
We need to explore how additionality should be defined
Time for change: ‘additionality’ and public debt market impact investing
A key macro theme that the markets seem less concerned with than maybe they should be
Underplayed? Opportunities from the US debt ceiling
Macro insight
Download our whitepaper for a comprehensive briefing on the issues around water and the implications for investors
The water challenge: a primer for investors
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Combining the advances of emerging economies with close to double-digit yields, is creating diverse emerging opportunities
The rising resilience of emerging markets
Despite recent turmoil in the banking sector, markets should be encouraged by the strength of the sector's underlying fundamentals
A position of strength? Banks look resilient despite the fears
MARKET OUTLOOK
As RBC BlueBay launches a new whitepaper on investing in water, we summarise three areas to be considering
Three priorities when investing in the water challenge
The AT1 market has progressed since the turmoil in March
The AT1 recovery and why fundamentals win over time
Patience, compromise, communication and commitment are key
Emerging markets – a high coupon affair or true love?
While developed markets contend with central bank responses to high inflation, emerging economies face different challenges
EM opportunities as economies navigate a new set of challenges
The how and the why of impact investing in public debt markets
An art, not a science: how to invest for impact
As the dust settles on the collapse of Credit Suisse, solid returns from AT1 bonds could be achievable
Why markets are underestimating the European banking sector
We are seeing value in European investment grade corporates relative to their US counterparts
Set to outperform? European corporates vs the US
Asset allocation
From the likelihood of meeting the 2% target to the risk of overtightening
Yoghurt economics? Five key questions on sticky inflation
Macro outlook
Rising issuer dispersion in investment grade corporate fixed income creates a fertile hunting ground for active managers
A fresh opportunity from dispersion?
Investment grade
Capital goods and packaging are just two areas that look attractive despite where we may be in the credit cycle
Don’t run for the hills! Cyclical sectors can offer value
Debt in these countries can be a useful diversifier as long as you selectively assess the performers and the defaulters
Frontier markets: healthy yields for the discerning investor?
Frontier markets
Emerging markets and long-short portfolios are worth considering right now
Home bias in decline? Ensuring proper global diversification
The outlook for interest rates, defaults and growth are all looking positive
The shape of things to come – are EM corporates ahead of the curve?
We believe that these countries could offer upside potential
Countries at a crossroads: two emerging markets to watch
Bond yields have continued to rise in recent months, but the time to buy has arrived
Q&A: Bonds are for the bold?
Markets appear to be undervaluing the resilience and profitability of European banks
Just how strong is the European banking sector?
Sector analysis
A number of European countries are doing well in reducing their debt-to-GDP ratios
European review: some deficits remain in the red
Sovereign debt
A number of countries seem to be moving in the right direction
Which countries appear to be on a positive debt trajectory?
Yields on many safe government bonds are at their highest levels since the 2008-09 global financial crisis, but this is largely matched by a rise in inflation expectations over the medium-term. While US Treasury bonds offer positive real yields when adjusted for future inflation, in Europe they remain negative. Even though much of the increase in inflation is a result of the Covid pandemic and the surge in energy prices, central banks will keep raising rates until they are confident that inflation is falling back toward target. Nonetheless, longer-dated government bonds remain attractive to investors wishing to diversify more growth-sensitive assets in portfolios. The global economic outlook is deteriorating, with repeated Covid-lockdowns and a property crash pulling down the Chinese economy, and Europe likely to be tipped into recession by the Russian-induced energy crisis. While the US economy remains on track for a ‘soft landing’, a period of below-trend growth is required to bring core inflation down. A sharper than expected global economic downturn will accelerate the decline in inflation, lower interest rate expectations and cause bonds to rally, helping to offset losses in investor portfolios from more growth-sensitive assets.
The last 12 months are the worst on record for the global fixed income market. The Bloomberg Global Agg bond index is down more than 20% from its peak in the middle of last year, as central banks hike interest rates in a belated attempt to curtail inflation. After such a dramatic re-pricing, investors are now asking: “Is the global bond bear market over?” The good news is that the bear market has banished negative yielding debt, put income back into fixed income and created pockets of value in credit. However, the bad news is that inflation is not yet tamed and central banks are not yet done with raising interest rates. The challenge for investors is to exploit opportunities arising from divergence and dispersion across global fixed income, as well as the pockets of outright value in credit.
“A sharper than expected global economic downturn will accelerate the decline in inflation, lower interest rate expectations and cause bonds to rally”
David Riley, chief investment strategist at BlueBay
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The challenging conditions are not yet over but there is value to be found, says David Riley
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Corporate bonds have re-priced dramatically this year from higher interest rates but also a meaningful widening in credit spreads. US sub-investment grade (or ‘junk’) rated corporate bonds currently offer a yield of 8½%, well above expected inflation over the medium term but even above current ‘spot’ inflation. Refinancing risk is very low and the average credit quality of companies that have tapped the high yield market is at an all-time high. US high yield corporate bond spreads at around 550 basis points (5½%) in our view fully compensate investors for the expected rise in corporate default rates. In Europe, investment-grade-rated company debt is yielding more than 3% with a credit spread of around 200 basis points, a level that has only been wider for a sustained period during the global financial and Eurozone sovereign debt crises. In my view, current spreads are full pricing a recession in Europe and the likely negative impact on corporate creditworthiness.
Corporate bonds offering value
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A mixed picture for government bonds
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For investors seeking higher returns, European bank subordinated debt such as contingent convertible (‘CoCo’) bonds are offering near 10% yield, much higher than the dividend yield on European bank stocks with less volatility and drawdown risk. Capital in European banks is near all-time highs and banks have set aside substantial revisions against potential loan losses. Our analysis of bank credit fundamentals implies that the risk that coupons on CoCo bonds are suspended is very low and the risk of conversion into equity lower still. In my view, investors are mis-pricing the bank debt because of the bad memories of the global financial crisis and while the market value of CoCo bonds can be volatile, these bonds will prove money good.
Subordinated debt mispricing continues to offer opportunities
For the more adventurous investor, there is a rich opportunity set in emerging markets debt and credit. Central banks in several emerging markets led the way with aggressive rate hikes starting last year, hence the resilience of their currencies even as the US dollar has been on a tear. Inflation and central bank interest rates are peaking, offering potential price appreciation as well as carry from much higher government bond yields than in developed markets. The JP Morgan emerging market ‘hard currency’ sovereign bond index has a yield close to 8%, despite an average investment grade credit rating. But caveat emptor is especially relevant for investors in emerging markets where there is a huge and widening divergence in country and corporate credit fundamentals.
Proactive emerging markets are looking resilient
It is not yet time to call the end of the bond bear market, with central banks aggressively hiking interest rates after failing to respond earlier to high and rising inflation. Nonetheless, yields on core fixed income are now at levels such that safe government bonds do offer some portfolio insurance against a severe global economic downturn. There are also attractive pockets of value in my opinion, notably European investment grade and bank subordinated debt, US high yield corporate bonds and selectively in emerging market debt.
Pockets of value
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Read more macro insights from the BlueBay team
Giving you the macro view
“Investors are mis-pricing the bank debt because of the bad memories of the global financial crisis”
October 2022
Sept 2022
Yes, that’s definitely a possibility, as it could afford more flexibility in the tools available to manage downside risks. That said, it could be argued that some long-only ESG funds can actually be quite resilient during a market downturn, given their bias towards quality stocks or issuers where there is a leaning towards more of a ‘best-in-class’ ESG approach.
This year’s challenging markets have led some to argue that long-only ESG funds are showing their limitations. There have been calls for a new wave of liquid alternative funds, on the basis that they could provide investors with greater diversification and might be better suited to market volatility. In this Q&A, My-Linh Ngo reflects on the possible risks and rewards of this approach. Can short selling affect real world change? Or could ambiguous regulation result in problems down the line?
“Arguably, having the flexibility to go long or short in long-short strategies can broaden the tools you have at your disposal to manage market moves”
My-Linh Ngo, portfolio manager and head of ESG Investment at BlueBay
ESG funds could have more flexibility to manage downside risks if they adopt liquid alternatives, says My-Linh Ngo, though the approach also comes with its challenges
There is certainly a need for regulators to provide explicit, clearer, and consistent guidance on the treatment of shorting activities in investment portfolios for ESG reporting purposes. Often what we observe is that there is no explicit reference to it. And even when there is, many requirements are written with a long-only, equity bias, and not recognising the diversity of instruments available in other asset classes like fixed income. This ambiguity is not helpful when, for instance, investors are having to prepare firm or portfolio-level reporting under recently introduced European ESG investment regulations such as the SFDR and taxonomy. There is little explicit guidance on how to account for shorts (e.g. via using CDS derivatives) in terms of whether they should be in scope or not when it comes to aggregating principal adverse impacts (PAIs) calculations.
Q. What about today’s regulations when it comes to shorting practices? Is this issue on regulators’ radar and are guidelines in place to ensure it is conducted fairly?
Q. It’s been a volatile year – do you see more attention shifting towards liquid alternatives in the ESG space, such as long/short funds?
Transparency is critical to counter concerns around greenwashing, but being clear about what the purpose of the disclosure is and why shorting has occurred is also important as it aids interpretation. For instance, when reporting on long/short investment exposures at the portfolio level, it’s critical to be clear about whether shorting has been used to manage exposure to financially material risks, or to evidence real-world ESG impacts associated with portfolio level positions. The two should not be conflated – reporting for ESG impact transparency is different from reporting for ESG investment risk exposure. A good example of the nuances of this has been shown in how investors are reporting on their portfolio carbon footprint. So best practice would be to provide full transparency to avoid misleading representation. This may mean reporting both long and short exposures to ESG factors separately, alongside any aggregation approaches which may include netting of long/short positions.
Q. Finally, what about current concerns around greenwashing? Do liquid alternative funds need to increase their ESG reporting transparency?
“Transparency is critical to counter concerns around greenwashing, but being clear about what the purpose of the disclosure is and why shorting has occurred is also important”
I would say that the reality is not as black and white. Historically speaking, active strategies can certainly offer better protection against market volatility than passive ones, particularly in market downturns. Arguably, having the flexibility to go long or short in long-short strategies can broaden the tools you have at your disposal to manage market moves. But let’s not forget that long-only strategies can still make use of derivatives, which can offer protection such as through buying CDS protection for a single name company or an index, and are often more liquid than simply shorting an individual name.
Q. More traditional ESG funds have generally thrived in bull markets. But are they well suited to volatility? Are investors missing an opportunity by focusing on long-only funds alone?
Learn more about the BlueBay Impact-Aligned Bond Fund
An active approach to responsible investing
Another significant growth driver would be China moving towards reopening following its zero-Covid policy. Additionally, October will see the 20th National Congress of the Chinese Communist Party, where there will be shifts in the power of the Chinese senior leadership and a new set of geopolitical and economic priorities. Finally, the Ukraine/Russia war continues to be a fundamental factor driving EM flows. “It is very difficult to position the portfolios for one outcome or another. However, if a positive scenario does materialise, this is not currently priced into the market and could be a big positive catalyst for broader risk assets,” says Kurdyavko.
There has been a long streak in outflows from emerging markets this year, but that narrative is changing. The US Federal Reserve’s ongoing battle to lower inflation may continue to be a headwind, but there are several key factors that could support opportunities in EM sovereign debt over the coming months. When it comes to fundamentals, energy price dynamics are the first and foremost of these. If energy and oil remain high, then current account dynamics will be supported for a number of commodity-producing countries in the Middle East and Latin America. “We expect energy prices to remain high. We think that the driver is not only the Ukraine/Russia war, but also supply constraints given the environmental and regulatory landscape putting a pause on 10-year capex gains,” says Polina Kurdyavko, head of emerging markets and senior portfolio manager at BlueBay. “Take the Petrobras’ of this world, or even the Middle East, where there is simply no more physical ability to dig oil out of the ground and also ESG constraints that play a big role when you must plan for the 15 years ahead,” she says. “We feel comfortable with the view on energy prices being sustained at a relatively high level because we don’t see any investment in increasing capacity. It's not that easy to find oil and gas majors that would commit multi-billion capex for a country over the next 10 years in the current environment.”
“We feel comfortable with the view on energy prices being sustained at a relatively high level because we don’t see any investment in increasing capacity”
Polina Kurdyavko, head of emerging markets and senior portfolio manager at BlueBay
EM sovereign debt has seen outflows but may turn the tables on frontier markets going forward, says Polina Kurdyavko
Pockets of value in sovereign debt
BlueBay takes a barbell approach to investing in emerging markets. On one end, BlueBay is overweight high-quality sovereigns that benefit from higher energy prices and have more of a valuation anchor to them, given the wider spreads, while actually running relatively low levels of credit risk. “As an example, our preferred exposure has been to a country like Oman for several years. It benefits both from the energy price dynamics but also from improving ESG risks, as a new budget is put forward which includes both cost controls and attention to environmental risks,” says Kurdyavko. “We also like Latin America. Countries like Mexico have benefited from the tailwind on commodities but also very tight fiscal balance sheets and quite hawkish monetary policy. This has ultimately led to quite a stable currency regime and helped domestic oil production and domestic activity,” she says. On the other end of the barbell, BlueBay is overweight in countries that have recently defaulted. “Those countries that have no debt to pay over the next two to three years are unlikely to default. In this camp, we would put countries like Argentina, which has reprofiled its debt a few years ago and extended the maturity profile,” she says. Kurdyavko says that the countries at both ends of the barbell are better positioned than those in the frontier markets, and that BlueBay remains cautious and underweight on the single B universe.
Learn more about BlueBay’s approach to emerging markets
A multi-layered approach
“Frontier markets have outperformed the rest of the emerging market universe over the last 15 years, but this dynamic is likely to change”
Frontier markets have seen a lot of inflows and have outperformed the rest of the emerging market universe over the last 15 years, but this dynamic is likely to change due to the current environment of lower growth and high funding costs. “The presence of local debt helped a number of economies cope relatively well in the current crisis and growth slowdown because they rely more on domestic markets,” says Kurdyavko. “However, those countries with less-deep local markets and a less-established domestic and international investor base could find themselves in a difficult position where they have to restructure debt, she says. Since July, there has been slightly more differentiation in countries and their respective performance. “Areas like the Middle East have held up and recovered quicker. In some areas where position is still relatively heavy or it’s a consensus overweight, we’ve seen recovery at a slower pace,” she says. “I would say that between now and year-end, I would expect that differentiation to widen, given the fundamental risk events that we could face between now and then,” she says.
As environmental, social and governance (ESG) investing continues to gain momentum, investors are increasingly paying attention to social issues. They want to know that wealth is created not only in an environmentally sustainable way, but in a socially responsible way to deliver real-world positive impact. In part, this is because investors are realising that the ‘E’ (environmental) and ‘S’ (social) of ESG are interlinked. For example, most people usually think of an issue like climate change as simply an environmental matter, but in fact it is deeply interlinked with social issues and even human rights, as a low carbon transition cannot happen if workers, communities and citizens are not part of the process to ensure no one is left behind. Otherwise the risk is growing social unrest and conflict, as well as a lack of skilled workers and a robust supply chain to facilitate the change needed. Ultimately, companies are not an island; they do not operate in isolation. Rather they are part of a system involving a range of internal as well as external stakeholders. Understanding the nature and quality of those stakeholder relations is key to understanding how likely the company is to be financially successful in the long term. As such, ESG is just about good business.
“It is about basic respect and enabling other relevant stakeholders to share in the benefits”
Investors are increasingly recognising that assessing social factors helps to minimise reputation and regulatory risk, according to My-Linh Ngo
BlueBay believes that incorporating ESG considerations makes good investment sense because it gives the firm a more holistic view of its investments. “That impact could be trying to capture risks to understand the extent that an entity is investment material. If there is an ethical component that potentially materially impacts the social licence to operate, this could then damage reputation, and reputational risk could turn into regulatory risk,” says Ngo. BlueBay has created a proprietary ESG evaluation framework to assess those issuers it looks to invest in. The framework is grounded in an emphasis on risk given that capital preservation is core to fixed income investing, with analysis conducted across a set of core and additional E, S and G topics. Issuers are ultimately assigned a qualitative ESG risk on a spectrum that ranges from ‘very high’ to ‘very low’ ESG risks. Deliberately, the ESG risk rating is not arrived at through formulaic quantitative approach, but rather allows for analysts to provide their judgement on the balance of the relevant significance of practices across the different E, S and G areas, which may take on different levels of significance in the specific company context. In the social pillar of the assessment, there are sub-topics that are examined for both corporate and sovereign debt issuers. “For companies, these span areas that relate to workers, supply chains, community impact and any sector-specific elements,” says Ngo. “For a sovereign issuer, we're looking at some of the more social measures about quality of life, human rights, freedom of speech, non-discrimination of different groups, discrimination against women and children, and more,” she says.
Measuring social risk helps inform on understanding investment risk
It’s fair to say that assessing companies and sovereigns in emerging markets on social matters can mean they do not compare as favourably as their developed market peers. Not surprising given the different base regulatory, geopolitical and cultural context. However, that doesn’t mean investors should be divesting from all emerging market issuers that are lagging in their ESG practices. “We have a meaningful presence in emerging economies – both directly and indirectly, as some of the issuers we invest in have global supply chains which include sourcing from such economies,” says Ngo. Whilst there may be some core social norms which all issuers should abide by, in practice, there can be areas where there are shades of grey, and a strong socio-cultural context which investors should be cognisant off and sensitive to. “When we look at sovereigns on the social side, for instance, investors may initially think it is not acceptable to invest in those which carry out the death penalty or lack a free press. But whilst there may be clear instances where change is not possible, in many others, that is not the case. If we fail to engage then that may not be responsible, and things will not change,” she argues. Furthermore Ngo says that we cannot realise the global sustainable development goals (SDGs) without bringing along emerging economies. “Those economies also have a right to develop and prosper. We in the Global North need to help them to develop, but we should do that by showing them that there is an alternative path to that which has been taken by western economies, and which arrives at the same quality of life outcomes but without the negative social and environmental impacts,” she says.
Emerging economies mustn’t be left behind
“We cannot realise the global sustainable development goals (SDGs) without bringing along emerging economies”
The Covid-19 pandemic shone a spotlight on the social aspect of ESG by putting health and wellness into greater focus. However, many of the big social issues are not new. Investors want to see how companies attract and retain talent, keep employees engaged and loyal, and ensure health and safety. They are also looking at their relationships with external stakeholders like customers, suppliers, communities and the physical environment. Alongside these broad social elements, particular industries will additionally have their own social indicators that investors will want to look at, says My-Linh Ngo, head of ESG Investment and portfolio manager at RBC BlueBay Asset Management. “If you look at the pharma sector, for example, you could argue that they have an additional dimension in terms of access to health. Investors would want to know to what extent the company is helping to facilitate the availability and affordability of their drugs where there is a critical need. Are they making appropriate R&D investments, waiving patent rights in certain cases? Are they running donation programmes, and working in partnerships?” says Ngo. In contrast, she explains, more unique social considerations for a financials company would be how they are promoting financial inclusion and ensuring fair lending practices. Things investors would look to consider here are: how are firms ensuring that their products and services are not unfairly disadvantaging certain communities or individuals in terms of access to banking services? What are they doing to promote financial literacy and ensure they are marketing their products responsibly to reduce indebtedness? Meanwhile, human rights stewardship is a crucial factor in tackling social issues while balancing a company’s engagement levels with regulation. “Ensuring responsible human rights practices is fundamental to a company's social license to operate because it's such a base principle that should be upheld. It is about basic respect and enabling other relevant stakeholders to share in the benefits while not potentially and disproportionately passing all the costs on to them,” says Ngo.
What investors are looking for
Sustainability is a term applied to many products in the asset management landscape, but in fixed income, this label does not always reflect all the underlying activities of corporates. It is no secret that sustainable investing in fixed income can often lack transparency, especially in emerging markets. However, that doesn’t mean there aren’t exciting investment opportunities. For this reason, it is important to look beyond green labels and determine which issuances are having the greatest impact while producing alpha. Conducting bottom-up research is essential because the quality of ESG-labelled bonds can vary tremendously. Some frameworks are extremely robust, showing that issued bonds are dedicated to new environmental projects. Conversely, you can have green-labelled bonds which are merely financing five-year-old projects or are refinancing older securities with only a few green bonds.
“Emerging markets provide a plethora of smaller, sustainable issuers to invest in”
Tom Moulds, senior portfolio manager at BlueBay
It you want the broadest possible opportunity set, then it is important to look at impact-aligned bonds that are not labelled as such, says Tom Moulds
While our approach to identifying sustainable opportunities remains constant across all jurisdictions, we have found that emerging markets provide a plethora of smaller, sustainable issuers to invest in. Indeed, around 20% of the BlueBay Impact-Aligned Bond Fund is invested in emerging markets, reflecting our desire to invest in a broad, global investment universe. You can compare this to the Bloomberg Global Investment Grade Corporate Bond Index, where emerging markets only account for around 5%. In recent years we have seen more bonds issued by corporates and sovereigns in emerging markets, providing exciting solutions in areas of the world where they can have the greatest impact. For instance, we have invested in bonds issued by the International Finance Facility for Immunisation, which provides funding for vaccine programmes in emerging economies. On the surface, it is labelled as a sovereign-backed issuance, but the use of the funds is very much that of a sustainable issuance. We’ve also recently invested in a bond issued by the International Bank for Reconstruction and Development. It's a sovereign-backed entity where proceeds are directed to emerging markets' social sustainability projects. However, part of the coupons are also used to protect rhino populations in South Africa – it is effectively a conservation as well as a development bank bond. These examples illustrate that investments in fixed income are not always what they appear on the surface – in many cases, they can be more sustainable. As the number of sustainable issuances grow and the global agenda continues to progress, we mustn’t solely rely on labels to guide our decision-making and let opportunities slip through the net.
Emerging market opportunity
When researching corporate issuers, we start by assessing the materiality of the organisations to see if they align with our sustainability themes and qualify under our framework. Once we’ve established whether the activities of an organisation are compatible with our investment philosophy, we have the freedom to invest in issuances that are not clearly labelled as sustainable. This is important as ESG-labelled bonds will not always represent the best investment from a returns perspective. For instance, an issuer which has qualified under our framework and is materially committed to sustainability could have a green bond and a non-green/vanilla bond. On the surface, the standard bond might not appear sustainable as it doesn’t have the green label, but its market impact is the same. As a result, if the vanilla bond trades cheaper than the green bond then it would represent the better investment opportunity.
Assessing materiality
November 2022
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As the world faces challenges from weakening growth, inflation and policy tightening, the good news for European high yield investors is that the underlying strength in the asset class has been on an improving trajectory over the last two decades.
“It will take a lot of economic stress to generate a pickup in defaults that surpasses a reversion to long-term averages of 2-4%”
Justin Jewell, partner and head of European high yield at BlueBay
Valuations are at levels that have historically generated compelling returns and credit metrics are at a decent starting point, says Justin Jewell
High yield
Governments are again taking away tails from consumers, and to some extent corporates, with substantial fiscal support to mitigate the impact of painfully elevated energy costs. This interventionist mindset supresses earnings shocks and defaults, which is good news for high yield investors. European high yield valuations are also trading at a discount to US high yield, as markets have priced in the higher probability of a deeper recession for Europe compared to the US. The relative valuation between both markets remains justifiable as there is no quick fix to Europe’s higher energy costs – but at some point, in our view, will offer a compelling opportunity when current headwinds began to ease.
Final remarks
The drawdowns in 2022 have been substantial and have meaningfully reset valuations of European high yield. The key investment question for our portfolios is whether this has sufficiently offset the building pressure on corporate earnings that we expect to cause an increase in credit stress and default loss. Defaults cluster because the two key inputs are earnings stress and credit availability. These are correlated factors, but with a strong starting position and capital-rich banks, our perspective is that it will take a lot of economic stress to generate a pickup in defaults that surpasses a reversion to long-term averages of 2-4%. The more insidious long-term challenge to cash flows comes from a regime change on funding costs that will take a long time to play out – with limited maturities and largely fixed coupon debt this is a multi-quarter or even multiyear process. There will be plenty of water to pass under the bridge in terms of economic data and activity, but our current trajectory will create pressure into H2 2023 and 2024.
Valuations reset
Read more insights from the BlueBay team
1. In the early 2000s, the asset class risk profile was dominated by smaller companies at an earlier stage of their business plans. The tech boom in particular brought roll-out cable operators with high capex and revenue pay-offs that were several years away. 2. In 2005-2008, pre-Global Financial Crisis (GFC), high yield markets were the key financing route for junior risk in leveraged buyouts; CCC supply increased, bringing businesses with more precarious balance sheets into public markets. 3. The index now has more mature multinational companies whose balance sheet vulnerabilities are offset with more dependable cashflows. Across multiple sectors there are national champion brands such as media, chemicals, automobiles, telecommunications and banking.
For investors, this is a noticeable improvement since the GFC, with the proportion of BB-rated credits over 70% in Europe compared to 53% at the end of 2008.
Perecentage of BB in European high yield index
Source: RBC BlueBay Asset Management, ICE BofA as at 31 October 2022. Note: European High Yield Index refers to the ICE BofA European Currency High Yield Constrained Index
Source: ICE BofA European Currency HY Constrained Index, as at 31 October 2022
European high yield spreads last 5 years
Source: ICE BofA, as at 31 October 2022. Note: 1. European High Yield refers to ICE BofA Single-B European High Yield Index (HE20) and US High Yield refers to ICE BofA Single-B US High Yield Index (H0A2) using LIBOR OAS
Spread differential of European B-rated high yield – US B-rated high yield over the last 10 years
1
Source: RBC BlueBay Asset Management, ICE BofA as at 31 October2022. Note: European High Yield Index refers to the ICE BofAEuropean Currency High Yield Constrained Index
Source: ICE BofA, as at 31 October 2022. Note: 1. European High Yield refers to ICE BofA Single-B European High Yield Index (HE20) and US High Yieldrefers to ICE BofA Single-B US High Yield Index (H0A2) using LIBOR OAS
Fixed income and other risk assets have come under pressure in 2022, following the global battle against inflation and the resultant significant tightening of financial conditions. This has been combined with several other factors to put pressure on risk asset valuations, including the effects of the war in Ukraine on natural resources and, more recently, a glut of supply following liquidations by asset managers on behalf of UK defined-benefit pension schemes. In some markets, valuations have become dislocated from fundamental risks. The key to investors taking advantage of dislocations is to target those that are more technical, rather than fundamental in nature. We believe that securitised credit markets have dislocated more than other fixed income asset classes and thus offer a very attractive opportunity. On top of attractive absolute and relative valuations, securitised credit is fundamentally robust and offers significant protection from defaults – preservation of capital in today’s environment is also of utmost importance. In this article, we dive deeper into the relative value of securitised credit versus other asset types to help identify the most attractive dislocations.
“European CLOs are more dislocated than their US counterparts and will outperform if spreads normalise”
Tom Mowl, portfolio manager, securitised credit & CLO mgmt. at BlueBay
There are opportunities for outsized, high quality, risk-adjusted returns, says Tom Mowl
Part of the reason for this difference is the higher fundamental risks faced by European corporates. However, we believe that prices have overshot fundamental concerns, given the embedded level of protection from defaults in CLOs, and that numerous technical factors are dominating price action. These include huge oversupply following liquidations from UK pension funds and the changing buyer base for European securitised credit. Finally, on CLOs, it is also important to note that this analysis can be replicated for different rating bands and the outcome is similar – European CLO valuations are dislocated from fundamentals across the capital structure.
CLOs are not the only sector of securitized credit markets that currently offer compelling value to investors. One other sector is US agency mortgage credit risk transfer (“CRT”) – these are securitisations issued by Fannie Mae and Freddie Mac and backed by prime mortgages in the US. The third chart below shows how valuations in this asset class have moved relative to corporate spreads at the BBB-rated level.
US agency mortgage CRT
“Mortgage issuance is expected to decline significantly due to higher rates and, as such, supply will also come down dramatically”
A good place to start is with collateralised loan obligations (“CLOs”) – these are securitisations backed by corporate loans. As the underlying collateral are corporate borrowers, this makes direct comparison to corporate bonds on a like-for-like basis possible, given the similar underlying risk factors. Chart 1 shows the credit spread on offer in BB-rated CLO bonds compared to BB-rated corporate bonds in Europe. The basis between the two is much wider than in less volatile periods and has dislocated close to Covid-era levels.
CLOs
Learn how BlueBay is meeting the needs of investors in both the investment-grade and higher-yielding space
By comparison, chart 2 gives the same analysis in the US, and shows that here the dislocation is much less meaningful. This means European CLOs are more dislocated than their US counterparts and will outperform if spreads normalise.
It’s always important to ask why valuations are dislocated. In this case – supply, a technical factor, in the early part of the year overwhelmed markets as Fannie Mae and Freddie Mac worked through huge mortgage volumes which originated in 2021. On top of this, the uncertainty of how the housing market would handle substantially higher mortgage rates fed into the volatility. This is a risk that can be mitigated by concentrating investments in more seasoned mortgages that have embedded house price appreciation, the fact that US mortgage underwriting has been high quality and that mortgages are fixed rate, i.e. the existing cohort does not come under pressure purely from an increase in current mortgage rates. Going forward, mortgage issuance is expected to decline significantly due to higher rates and, as such, supply will also come down dramatically.
Our final example is UK RMBS. AA-rated bonds are extremely well protected from increased fundamental risks, yet all the factors discussed above and the current uncertainty the UK faces has led these bonds to fall dramatically in price. This can be seen relative to UK corporate bonds in chart 4. In order for a AA-rated bond to be impaired and not return full principal, then cumulative losses need to reach around 20% in the underlying pool of mortgages – when this is compared to ~4% losses witnessed during the GFC (a period where mortgage underwriting was much worse quality), one can see that these bonds are extremely well protected fundamentally and that the change in valuations is driven by technical factors.
UK RMBS
Source: Wells Fargo, Bloomberg
Chart 1: Credit spread on offer in BB-rated CLO bonds compared to BB-rated corporate bonds in Europe
Chart 2: Credit spread on offer in BB-rated CLO bonds compared to BB-rated corporate bonds in the US
Chart 3: Basis between BBB CRT new issue and BBB corps
Source: Goldman Sachs
Chart 4: Basis between UK NC AA and UK AA corps
Source: Citi
Andrzej Skiba (AS): We feel that there is opportunity waiting to be uncovered in fixed income. With yields in excess of 9%, we have a slight preference for US high yield assets, but we see opportunities in the high-grade space, too.
“A few areas of the quality credit space stand out, specifically short-duration high-grade bonds in the US”
Andrzej Skiba, head of US fixed income at BlueBay
Recent times have been challenging but there is still potential in the credit landscape, say Andrzej Skiba and Tim Leary
Tim Leary, senior portfolio manager, leveraged finance at BlueBay
“Perhaps the doom-and-gloom prospects for Europe might be a bit overdone”
Q. Given the current climate of economic volatility, do you feel that there is still opportunity in the fixed income arena?
Q. One of the most unexpected aspects of the last 12 months has been how well margins have held up for corporates on an earnings basis. Are you surprised by this?
Tim Leary (TL): A misconception about high yield and leveraged finance broadly is that inflation is a net negative. We’re at all-time highs for EBITDA margin at an index level, with five consecutive quarters of deleveraging through growth as companies push through prices onto their consumers and are generating more cash flow. That puts high yield in the most attractive leverage position it has seen in over 10 years. Corporate balance sheets are in a very good position, and they’ve also locked in their cost of capital as they’ve refinanced so much of their debt stack into fixed rate bonds. The amount of cash flow relative to annual interest expense is at all-time highs. If we are entering into a meaningful recession, we believe high yield is well-positioned to weather the storm.
Q. With so much uncertainty anticipated, many institutions might prefer to focus on higher quality assets before dipping a toe in high yield. Is this reasonable?
AS: Very reasonable. If the pain caused by the higher government bond yields is almost at an end, the total returns on a go-forward basis should be positive because the carry will offset any incremental pain. Even if spreads widen in response to weaker forward earnings, that should be captured and offset by the carry. A few areas of the quality credit space stand out, specifically short-duration high-grade bonds in the US, where the market has a high degree of comfort that companies will pay the bills over the next years with that space yielding over 5%. We’re seeing greater engagement in those types of bonds because clients want to take advantage of inverted yield curves, where they’re buying shorter duration but actually getting paid more because of the steepness of the Treasury yields.
Q. Right now, investors in the commercial mortgage-backed securities (CMBS) space can gain exposure to opportunistic allocations that, compared to their reference rates, offer spreads of over nearly 350 bps in the AA space and 200 bps in AAA. What are your thoughts on this?
AS: By historical standards this is interesting, and a lot of those securities are quite short in maturity. Things have to get really ugly before you start losing money, given the carry that you are getting paid. After being down on the agency mortgage-backed security (MBS) space for some time because the market was complacent about the impact of the Fed potentially selling some MBS securities further down the line, we’re starting to look favourably at the agency MBS space, especially when you look at specified pools. Rather than generic securities, those pools that have exposure to parts of the US offer some favourable dynamics, either in terms of prepayment rates or in terms of the type of the borrowers. That was not the case a few months ago.
Q. Are you in agreement with the pessimistic prospects concerning Europe?
AS: Perhaps the doom-and-gloom prospects for Europe might be a bit overdone. Newly announced fiscal handouts – some straight from government coffers – will help offset effects of higher energy prices and increase debt of the issuing countries. Some of them are a function of windfall taxes from energy companies that are greatly benefiting from power prices in Europe. What it all means is that if recession in Europe is inevitable, which it is in our view, the depth of that recession will likely be less acute than otherwise would have been the case.
Q. Finally, what is your outlook for US assets?
AS: We believe US assets should outperform on a going forward basis, reflecting the strength of the underlying economy. With uncertainty as high as it is, when we speak to investors across the world, they feel much more comfortable holding US assets rather than betting on Europe or China at this stage.
It has been a tumultuous time in the European energy market, with the disruption to Russian gas flows exacerbated by a long dry summer affecting hydro, nuclear and coal-based power generation. The EU has reacted with a swathe of measures to try to stabilise markets and lower energy costs for consumers, including:
“Demand destruction will be key to Europe making it through the winter without Russian gas”
Robert Lambert, portfolio manager, investment grade at BlueBay
The situation is challenging but we would expect credit metrics to remain resilient across the European energy sector, says Robert Lambert
Demand destruction will be key to Europe making it through the winter without Russian gas, and the EU has targeted a 15% cut as part of its “Save Gas for a Safe Winter” plan. The plan focuses on substitution of gas with other fuels and efficiency improvements but is also likely to entail production cuts and is likely to exacerbate supply chain issues. The International Energy Agency (IEA) has forecast a 10% drop in annual gas demand for 2022, the largest drop on record, and reflects the expectation of higher gas prices curbing consumer usage, causing a 3% fall in natural gas power generation and a 20% fall in industrial gas demand. In addition to reduced demand, replacement of Russian flows will rely on Europe continuing to outcompete Asia to secure an adequate spot price for liquefied natural gas (LNG). While Europe has benefited from buyers in Asia being deterred by high prices, the tussle for cargoes could intensify if Asia sees a colder-than-normal winter or hotter-than-usual summer. Europe is set to become reliant on the spot LNG market as more than eight million metric tons worth of contracts expire in 2023.
Can the largest drop in gas demand on record help to reduce Europe’s energy woes?
Energy network companies are well-placed in the energy complex. European utilities have been one of the worst performing sectors year-to-date, underperforming all cyclical sectors except for real estate and other financials. Recent government intervention has levelled the field somewhat, with extraordinary support for the more challenged companies and windfall taxes for the winners. However, with energy shortages looking less likely through the winter, we would expect credit metrics to remain resilient across the sector. Meanwhile, long-term energy transition strategies should be largely unaffected, with a significant ramp up in renewables and grid investment. Throughout the energy crisis, energy network operators have proved to be resilient and remain our favoured investment in the utility space. Revenues, costs and returns of network companies are pre-set via regulated price controls (grid operators do not take positions in energy market). Price, volume, government intervention and liquidity impact should all be negligible. Inflation-protection mechanisms such as automatic indexing, whereby growth in revenues and/or the regulated asset base of a company are directly linked to an inflation index, are also supportive in the current environment.
The investment outlook?
“With energy shortages looking less likely through the winter, we would expect credit metrics to remain resilient across the sector”
In addition, the EU has proposed liquidity support measures for energy companies seeing high collateral demands, the setting up of a new EU gas benchmark, and longer-term reforms of the electricity market to decouple gas and power prices. Germany and the UK are also looking to extend the lives of nuclear reactors marked for decommissioning and reinstating coal plants that were formally slated for closure or had already been mothballed. This has somewhat stabilised gas and electricity prices, albeit still at elevated levels. However, the risk of further disruption remains heightened with damage to both Nord Stream pipelines and with the Russian government threatening sanctions against one of Ukraine’s oil and gas companies, which transports gas from Russia through Ukraine into Europe. This would threaten access to the remaining 10% of Russian gas flows.
Read more about BlueBay’s approach to the investment-grade universe
We are fundamental investors
A ‘solidarity contribution’ of 33% imposed on the extra profits of fossil fuel companies for FY22; A ‘revenue cap’ of €180 per megawatt hour (MWh) on the market revenues of non-gas power generators (e.g. renewables, nuclear etc) for one year; Power demand reduction targets including a 10% monthly reduction target, and a peak hours’ reduction target of at least 5%.
• • •
The upside from the current energy market disruption is likely to be an acceleration in renewables deployment and increased investment in hydrogen which, as yet, fails to register materially on most forecasts for the EU power generation mix. The economics for consumers remains challenging but stack up for a range of sectors – including long-haul transport, chemicals, as well as iron and steel – where it is proving difficult to meaningfully reduce emissions. With declining costs for renewable electricity, in particular from solar photovoltaics (PV) and wind, interest is growing in electrolytic hydrogen as an energy store and there have been several demonstration projects in recent years.
Silver lining to the energy crisis
In the near term, an unfortunate effect of the energy crunch will be that we burn more coal – with strong returns for utilities that are forced to extend or reopen capacity. Based on current economic and market trends, the IEA forecasts global coal consumption to rise by 0.7% in 2022 to eight billion tonnes. This would match the record set in 2013, with risks to the upside if the Chinese economy recovers before the end of the year. Whilst much of the demand comes from emerging markets such as India, coal consumption in Europe is expected to rise by more than 7% in 2022, on top of last year’s 14% jump. A search for oil-based alternatives to gas in other sectors may prop up demand for middle-distillate oil products, with the knock-on effect of further emissions. There are some bright spots that deserve to be mentioned. A squeezed polysilicon market will breathe a sigh of relief for photovoltaic manufacturers as China brings new factories online later in the year. And, while steel prices and the cost of shipping remain well above pre-pandemic averages, they have tumbled from their previous heights. Look elsewhere and the picture is gloomier: the global supply of lithium will, for instance, struggle to match demand in the years to come. That could continue to pressure battery cathode prices even if supply chain issues ease.
A lump of coal for Christmas
Source: US Energy Information Administration, International Energy Outlook 2021 ‘Reference Case’
Projected power generation mix
History
Projections
Source: US Energy Information Administration, InternationalEnergy Outlook 2021 ‘Reference Case’
“We believe the US will see a relatively benign recession compared to Europe, where fiscal policy support will be necessary”
Andrzej Skiba, head of US Fixed Income at BlueBay
The bond market has been through a tumultuous time recently but what is next and how could the current situation evolve? Andrzej Skiba assesses the global economic situation and where investment opportunities lie
Learn more about how our investment strategies provide exposure to global leveraged finance markets
Adding value over the long term
Q. After a decade of zero, if not negative rates, monetary policy has drastically changed. What are the consequences for the bond market?
In a word - pain. The move higher in interest rates across major global central banks (including the Federal Reserve and ECB) occurred at a time when duration, or the sensitivity of bond prices to interest rate moves, was near its all-time high. This has driven bond prices dramatically lower as rates have risen. The negative impact on total returns was substantial – many segments of the global fixed income universe experienced declines of more than 15% year-to-date. On a more positive note, bond prices are now at levels where yields are much more compelling and could well offer sufficient income to insulate from further upward interest rate moves.
Q. What is the impact on debt refinancing operations by governments and private companies, including in regard to investments in sustainability?
High yield new issuance has slowed dramatically in 2022 for two reasons. First and foremost, 2020 and 2021 saw sequential record new issue supply. Over half of that supply was used to refinance existing debt. As a result, there is very little corporate debt needs to be refinanced over the next two years. Looking at the wider fixed income universe, we note that there was over $1trn of ESG-related financings in 2021 across sovereigns and corporates, with sustainability-related supply matching green debt issuance for the first time
Source: Macrobond: latest data at 3 October 2022
Fed funds and US Treasury 10yr yield
Source: JPMorgan at 3 October
US high yield new issuance over time
Q. The new government in Italy and British fiscal policy are two new factors in Europe: how will the two scenarios evolve, and what impact will they have on investments?
In the UK, the impact of the Liz Truss’ and Kwasi Kwarteng’s economic agenda sent shockwaves through domestic markets. Despite the replacement of Kwarteng with Jeremy Hunt, policy U-turns and Truss’ resignation, we think investors will continue to be sceptical of UK assets and therefore will continue to attach a substantial ‘risk premium’ in UK assets in the months ahead. In Italy, incoming prime minister Meloni faces the same challenges on the energy front as much of Europe which will dominate fiscal policy over the coming quarters. Domestically, driving the tax and pension reform will be high on the list of post-election promises. While there is scope for some turbulence internally heading into the budget season, particularly from Lega and regarding the flat tax reform, we think senior coalition members, the Brothers of Italy, will opt for a more responsible, targeted approach. There is little to gain in the short-term in being confrontational with EU rules, and more to lose through Next Gen EU grants and the ECB TPI backstop. Overall, we think the communication on the fiscal front will be gradual and typically conservative, allowing the focus to switch to the growth part of the agenda.
Q. The US is looking to get inflation under control whilst trying to balance the risks of an economy in recession. What should investors consider?
It will be incredibly difficult to tame inflation without slowing the economy to the point of a recession. The Fed has an explicit goal of tightening financial conditions, so their monetary policy will increase the cost of capital for corporates and individuals alike. Eventually unemployment rates will increase, and growth will slow to the point of recession. We believe the US will see a relatively benign recession compared to Europe, where fiscal policy support will be necessary to prevent a challenging scenario. That said, in our opinion, default rates will not reach levels seen in previous recessions. High yield leverage and interest coverage ratios are strong by historical measures, which demonstrates that the asset class is well prepared to weather the storm ahead.
Q. Which sectors and geographical areas offer the best investment opportunities in this context?
We are overweight non-cyclical issuers and have a regional preference for corporates in the United States. The American consumer will remain strong while unemployment is low. The world shares in the pain of inflation, but energy costs are far more severe in Europe than in the US. That said, there are pockets of value in each sector across high yield. We prefer shorter duration, senior secured, single B-rated bonds, while remaining underweight CCC-rated bonds that are most vulnerable to an economic slowdown. We prefer investments in larger issuers whose debt trades often and is considered liquid. That allows us to remain nimble in volatile and uncertain markets.
302.1
245.6
368.1
398.5
355.7
293.2
286.2
328.1
187.4
286.6
449.9
483.0
90.0
The path ahead for markets remains uncertain, and BlueBay continues to believe a cautious investment stance is merited for now. Recession fears have risen, and for markets to stabilise, we need to see evidence that inflation is heading back towards central bank targets. But this theme of uncertainty is certainly not confined to financial markets. It is equally applicable when thinking about how sustainability trends and developments will evolve. With key events before year end, including the recent UN Climate Change Conference and the Convention on Biological Diversity in December, we are finding out just how much short-term economic worries are overriding efforts to tackle longer-term priorities, which if left unaddressed, will lead to significant material costs in financial, human and environmental terms. Progress will continue to be uneven in 2023. However, despite the challenging headwinds, we still maintain that there is long-term structural demand for investment practices which take account of ESG factors to better manage risks (‘doing well’), as well as growing interest to direct capital towards ‘doing good’.
“A priority for next year will be to better understand how the systems-change concept can be applied to our future reporting”
There is still long-term structural demand for sustainable investment practices, and BlueBay will continue to refine its strategy, says My-Linh Ngo
More broadly, we recognise the need to further enhance and refine our approach. As such, a priority for next year will be to better understand how the systems-change concept (which sets out a framework for thinking about how change comes about) can be applied to our future reporting, and to continue to evaluate data, tools and methodologies to evidence positive contributions. We also look forward to working with peers and organisations active in the sustainability and impact investing space to better understand how we can contribute to thinking and practice on this when it comes to fixed income investing.
Taking the strategy forward
Given that BlueBay's impact-aligned strategy includes an explicit aim to contribute positively to environmental (and social) outcomes, over the course of the next year we will be considering the extent to which it is also possible to incorporate a portfolio-level net-zero goal. However, we continue to reflect on what is the most credible approach to take to do this, such as the most relevant metric to adopt. Currently, a common and popular approach appears to be to mirror the global targets, i.e. making the portfolio Paris aligned by 2050 to a 1.5 degree Celsius scenario, setting an interim target of 50% reduction by 2030 (adopting the metric of WACI), as well as an annual portfolio self-decarbonisation target of 7%. Looking at our portfolio WACI, we are already performing favourably, with a footprint that is 50% less carbon intensive than the Global IG Corp Index. However, we view the use of the WACI metric to be problematic, given the backward-looking nature of this datapoint and its limited focus on scope 1 and 2 emissions. This can penalise companies with a high operational footprint but which are producing products to help other companies reduce their associated emissions. Yet, if we elect to use a forward-looking metric like percentage of issuers with net-zero (science-based) targets (and potentially require them to be certified to the Science-Based Targets initiative), not only is the coverage of such issuers currently low, but we risk undermining our ability to invest in small-to mid-cap companies or those in emerging markets where resourcing and awareness are limited. Given these dynamics, we will explore further how to approach this issue.
Exploring a fund net-zero commitment
The themes we have outlined for our strategy span many of the critical areas where solutions will be needed and focus on the opportunities where investors can look to ‘do well’ whilst also ‘doing good’. This is because beyond the sustainability case, we believe the economic case continues to grow. However, there is an increasing sense that the window of opportunity to reduce the worst effects of climate change and nature loss is fast closing, with some of these being irreversible. At a time when we are seeing more and more scrutiny towards sustainable investing practices, and rightly so, we are proud of the impact-aligned framework we have created, and the growing portfolio we have of issuers and bonds seeking to make a positive difference.
The window of opportunity is closing
“We will be considering the extent to which it is also possible to incorporate a portfolio-level net-zero goal”
Some of the most common questions we receive from clients are around engagement. Are we able to engage with investees given that we are lenders rather than equity investors? Do we engage with sovereigns as well as corporates? Is engagement preferable to divestment? The answer to all these questions is broadly “yes”, but there are plenty of nuances to take on board. In this article I’ll talk about our approach to engagement and some of the challenges that come with it.
“Engagement is certainly worthwhile and can be very successful”
Lucy Byrne, senior ESG analyst at BlueBay
Some issuers are easier to reach out to than others, but engagement remains a valuable tool, says Lucy Byrne
Our analysts and investment teams have a lot of engagement and interaction with sovereigns, as well as with bodies associated with them, the media and NGOs. Often this is on an insight basis in order to enhance our analysis of the issuer, but we do also seek to influence. Creating change among sovereigns can be slower than with a corporate, but it is possible. When we are talking directly to sovereigns, some conversations are easier to have than others. Talking to China or Saudi Arabia about human rights, for example, is not going to be straightforward. We try to build up trust in the first instance, before coming on to explain why these issues are important to our investors and what might happen with our lending if we’re not able to give them comfort.
Can you engage with sovereigns as well as corporates?
There can be an expectation that that every engagement leads to an outcome that we can measure and attribute to ourselves, but we try to manage expectations around that. What we can say though is that engagement is certainly worthwhile and can be very successful. One area where we have been active is in UK water utilities, with priority topics including management of leakage into rivers, development of sustainable finance strategies to support infrastructure upgrades and planning for drought prevention and water affordability. Having spoken to a number of companies last year, we revisited them this year to determine what progress they’ve made. One of the worst performing companies has been Southern Water, which received record fines after pleading guild to thousands of illegal discharges of sewage. However, it has since seen sweeping changes in senior management, and despite scoring poorly in 2021, has made some strong progress on a number of metrics. Meanwhile, an example of our sovereign engagement came in September, when our emerging markets investment team met with Jamaica’s finance minister Nigel Clarke and colleagues. When we highlighted that Jamaica screens as un-investable for us due to their failure to sign and ratify the UN Convention on Torture, the Finance Ministry team were surprised. The issue had never been raised with them before. We clarified its potential impact on market appetite and they promised to follow up immediately. We’re now watching closely for progress.
One of the three pillars of how we approach ESG is “stewardship”. In practice, this mainly refers to our engagement work – we do also do some proxy voting, for example in leveraged finance or convertibles, but generally it’s not a route that is available to us in fixed income. We split engagement itself into two buckets. The first is “insight”, where we’re engaging to gain additional information or understanding; and the second is “influence”, where we’re seeking and outcome or to drive change. There are various mechanisms through which we can engage. We might be making calls, we might be having meetings, we might be writing letters. We can do it on our own or we can do it in partnership with other investors. The latter can be particularly powerful because if several groups put their capital behind one topic, then that gives us a lot more sway. There will always be those issuers that are a bit trickier to engage, particularly on the emerging markets side. But things are improving because regulatory reporting requirements have increased the focus on ESG data and disclosures. That’s trickling down to the issuers, who are being told that they have to provide this information or they can’t be included in certain funds.
What does BlueBay’s engagement look like?
We think engagement and divestment are both useful tools in their own right to try to drive change. We do receive a lot of requests from clients to have blanket exclusions on certain topics. That may be legitimate on moral grounds, and they may also have some impact if the investment industry is taking a collective decision to divest. However, the reality is that in many cases an issuer will simply be able to obtain capital from other investors. If so then it may be more effective to be a holder in the issuer and retain the investment case to continue the dialogue. If we then feel that an issuer isn’t being sufficiently responsive to our engagement efforts, then there is an escalation route that we can take. We start off by setting the objectives that we want to achieve over a particular timeframe. These need to be realistic and we need to be prepared to adapt the timeframe if necessary. Then if the engagement is not progressing in the way we want it to, we can choose to reduce our exposure, or even short the issuer. Full divestment is there as the final option if we feel we’ve done everything we can.
Is engagement preferable to divestment?
“We try to build up trust in the first instance, before coming on to explain why these issues are important to our investors”
Is BlueBay’s engagement having a tangible impact?
There is always a case to be made for emerging markets (EMs), but the argument for structural allocation to EM fixed income is especially compelling right now. We asked Polina Kurdyavko to share her thoughts on the current challenges facing the asset class and what investors should look out for.
“Due to a structural lack of supply, I don’t anticipate a sharp downward adjustment of commodities prices”
Emerging Markets
“When uncertainty recedes as the Fed stops hiking rates, we feel there’s a compelling proposition for valuations in emerging market FX”
Q. Why is EM fixed income so compelling right now?
Even in this challenging environment, EMs account for half of global GDP and two-thirds of the global growth. In more established EM countries, EM debt – even dollar-denominated – is providing over 10% yield. That is something we haven’t seen consistently since the early 2000s. However, there are no risk-free assets, and diversification still matters in the current environment. War in Europe could end tomorrow – or not. Gas supply could start to normalise, and commodity prices start to correct – or not. It’s therefore difficult for investors to position themselves for binary scenarios that depend solely on developed markets.
Q. At present, there are strong tailwinds from higher commodity prices and more orthodox monetary policy. How does this impact EM commodity exporters?
Two-thirds of EM countries are commodity exporters, and higher commodity prices have helped to improve current account balances. On the one hand you have countries who already have positive current account balances – Saudi Arabia has gone from 5% to 15% surplus. But even countries that had current account deficits of 3% to 4% have reduced to 1%, as is the case in some Latin American countries. That is a significant indication of lower vulnerability in emerging market economies, even more so than in the 1980s and early 2000s. Due to a structural lack of supply, I don’t anticipate a sharp downward adjustment of commodities prices, even if BlueBay’s best-case scenario materialises and the conflict in Ukraine ends soon. That’s a positive for commodities exporters in EMs.
Q. More orthodox monetary policy is the biggest structural change in emerging markets over the last 20 years. What are your thoughts on this?
Firstly, double-digit inflation is common in EMs, rather than some “new” thing to worry about, so policymakers don’t have the luxury of acting only after inflation reaches elevated levels. That’s why EM policymakers have racked up 300 interest rate hikes since the beginning of 2021, pre-emptively and hawkishly managing inflation down. We’re already seeing a reduction in inflation in many Latin American countries. Earlier pre-emptive measures by central banks, combined with positive current account dynamics, also means that EM currencies have been relatively stable – and that’s another reason EMs are well positioned at the moment. Today, emerging market fixed income accounts for about $23trn, with only $4trn denominated in USD. The remainder is local currency. That is a noteworthy transition that has occurred over the past 20 years and merits the attention of investors. As monetary policy becomes more orthodox and confidence in policymakers rises, domestic investors – pension funds, domestic banks, and insurance companies – are more willing to fund the fiscal deficit when it comes to sovereign or corporate balance sheets. This provides additional stability in years like 2022, where dollar-denominated sovereign and corporate issuance has halved. Most EMs with well-established domestic markets have reverted to them, reducing dependence on external markets.
Q. EM foreign exchange (FX) has devalued by more than 60% in nominal terms over the last 12 years, whilst the dollar has experienced a bull run for more than 10 years. Do you believe this will continue?
No, I believe that run is coming to a close. Strong current account dynamics support emerging market currencies, which have outperformed developed market currencies like the euro or pound, year to date. Eventually, when uncertainty recedes as the Fed stops hiking rates, we feel there’s a compelling proposition for valuations in emerging market FX. Another aspect of currency valuations is the difference between real yields in emerging markets versus real yields in developed markets, which today is about 5% – the highest it has ever been. Assigning valuation anchors for local debt is admittedly a challenge, which means volatility in local currency will remain elevated during uncertain times. However, over a five- or 10-year horizon, I have a high level of confidence that local currency will actually outperform hard currency overall, based on the US dollar’s bull run coming to an end.
After a decade of ‘lowflation’, 2022 was the year when inflation returned with a vengeance. Looking forward, 2023 will be characterised by peaks in inflation and interest rates and troughs in growth. Inflation is close to peaking and will be lower by the end of 2023, but how far and fast inflation will fall is a key source of macro and market uncertainty. Central banks will reach the end of rate hiking cycles and the market focus will shift to how deep the economic trough will be. We are forecasting that the US economy enters a short and moderate recession, contracting by 0.6% in 2023 with the trough late in the year and recovery into 2024. The cumulative impact of the tightening in monetary and financial conditions will meaningfully cool the economy, with unemployment likely rising to around 5% and consumption spending weakening as households exhaust ‘excess savings’ amidst rising layoffs. Business investment and net exports will also decline, reflecting global economic weakness, while the housing market correction is set to deepen.
The US economy could enter a short and moderate recession while Europe’s downturn could be deeper, predicts the team at RBC BlueBay
Read more insights from RBC BlueBay
February 2023
At 2%, the global economy will expand at its slowest pace in 40 years (excluding the global financial crisis and pandemic recessions). The extent that central banks will be able to adjust policy in response to the deteriorating growth outlook will depend on how far and fast inflation falls. Upside risks for the global economy and financial assets come from a ‘soft landing’ rather than recession in the US on the back of a faster decline in inflation that supports a pick-up in household income and spending, and allows the Fed to accommodate an easing in financial conditions. The recession in Europe could also prove less severe than currently forecast with a mild winter so far and ample gas storage. But on the downside, geopolitics could be the source of another shock to the global economy through higher commodity prices which would negatively impact confidence and market volatility. The tightening of monetary and financial conditions could also expose more ‘weak links’ in addition to the collapse of the crypto sector and UK pension fund liability-driven investment strategies.
Global outlook
Note: Shaded area shows range of forecasts reported by Bloomberg excluding 10% decile tails. Source: Bloomberg, RBC BlueBay forecast; latest monthly data for October 2022.
Falling US inflation - but how far and how fast?
The trough in growth will likely be in the middle of 2023 but, as inflation continues to fall, household incomes will start to recover and the Fed will have room to support this recovery with policy easing into 2024. Moreover, the strength of private sector balance sheets and the (regulated) financial system mitigates potentially negative feedback loops that would otherwise result in a deeper and more prolonged recession. Our baseline forecast is that underlying US inflation (core PCE) will be around 3% in Q4 2023. Even if the economy is not in outright recession it will be well below potential, and the labour market will no longer be ‘extremely tight’ with falling vacancies and rising layoffs. With the economy at best stagnating in the second half of the year and the Fed funds rate at around 5%, the Fed will have room for modest rate cuts even with inflation above target so long as it is confident that inflation will continue to fall. If the recession is deeper than we forecast, inflation will fall further and faster and the Fed will start cutting rates sooner and by more.
“Higher energy prices and tight labour markets are spilling over into core inflation that will stay sticky”
Europe is already on the brink of recession due to the surge in energy prices and our forecast implies a deeper recession than in the US with a relatively weak recovery through the latter part of the year. Inflation will likely peak around the turn of the year, and headline inflation will fall through the rest of 2023 as the contribution of higher energy and food prices to inflation drop out due to base effects. However, higher energy prices and tight labour markets are spilling over into core inflation that will stay sticky, prompting the ECB to continue to raise rates to a peak of around 2.5% to 3.0% in the first half of the year. China is forecast to post modestly stronger growth in 2023 on the back of a pick-up in consumption as Covid restrictions are relaxed. However, the transition away from ‘zero-Covid’ is likely to be in fits and starts and sensitive to the pace of vaccination, as well as infection outbreaks, and will continue to constrain consumption. The property downturn will also continue to weigh on activity throughout the year.
Global growth forecast (annual % change)
Source: Consensus forecasts as reported by Bloomberg, 21 November 2022; RBC BlueBay forecasts; October 2022.
Tap to view
World
DM
EM
China
US
Euro area
Japan
-1.4
-0.4
-0.6
1.6
2.6
3.6
3.5 2.0
4.6
2022f
This year kicks off with macro markets bang in the middle of a difficult transition phase. Positive price action in fixed income markets and stocks in October and November last year could be interpreted as the market front running a more benign outlook for macro data and central bank policy. However, our fear is that the Federal Reserve (Fed) and the ECB have other ideas and are not yet ready to sanction any kind of pivot. That would need inflation and economic activity indicators to continue to weaken. As we move into this new phase, we have identified seven key macro market themes for 2023:
“Alternative strategies are often more flexible and offer more diversified sources of returns than traditional long-only strategies”
Russel Matthews, BlueBay senior portfolio manager, global macro, RBC BlueBay Asset Management
All eyes are on the Fed but China’s reopening might be more significant, says Russel Matthews
Forget the Fed pivot, this is the real pivot. One of the strongest themes right now in global macro is China’s reopening, which is gathering pace. The most obvious implication is a return of cross-border travel from the Chinese. And the timeline for this seems to be even more accelerated than previously expected, as evidenced by the scrapping of all quarantine measures for inbound travellers to China. Furthermore, domestic demand in China should step up as activity and mobility rise. This will have important implications for oil and energy and will benefit commodity exporters: Australia, Brazil, and Chile, to name a few. While the China reopening theme is a few months old, it only started to gather steam towards the end of the year-end when investors were reluctant to allocate in size to new themes. And more importantly, there has been scepticism on this theme at every stage. So there’s more to go here and there could be unrecognised potential for investors.
2. China’s reopening is the real pivot
A meaningful pivot from the Fed becomes more realistic if labour markets soften materially (US payrolls declining towards flat, job openings falling rapidly and the claimant report showing a meaningful increase). And then financial assets can continue to rally. However, the counterfactual also applies. If the US labour market does not soften, then the Fed will continue to hike the US base rate well above 5% and will not cut rates towards the end of the year. Currently, the market is dismissing the concerns of the Fed, and pricing a fairly benign path for interest rates over the next 12-18 months: the terminal rate below 5% in Q1 and then at least two cuts of 0.25% before year-end.
1. All eyes on the pivot
When we look at the macro data points that came out in December, there are nascent signs that inflation is moderating in many parts of the global economy, and the latest CPI data out of the US was most encouraging. The burden of proof has shifted heavily to macro data points in the first quarter to justify the more positive tone and the benign path for monetary policy that has emerged in recent months. There is an open question of whether inflation falls back to target in a relatively short time, and there is a myriad of macro factors that present crosswinds to the macro outlook. We have doubts that these headwinds will be superseded by the prospect of the major central banks shifting to a rate-cutting mode. Aside from the strong labour market, the energy crisis and demands that climate change puts on economic structures will remain important and will present new threats and opportunities. There are also heightened geopolitical tensions and uncertainty over how the conflict between Russia and Ukraine will play out.
3. Moderating Inflation
“Domestic demand in China should step up as activity and mobility rise. This will have important implications for oil and energy”
We continue to find a strong focus on alternatives through multiple channels (wealth management, LDI, private banking and general financial institutions). While there has been an appreciation of the degree of value creation in the long-only space, given where core yields are, and with spreads also historically attractive in some areas, alongside that, we also find a healthy amount of scepticism that we can revert to a pre-Covid world. Alternative strategies are often more flexible and offer more diversified sources of returns than traditional long-only strategies. In particular, proven absolute return macro strategies will remain in high demand.
5. Alternatives should provide resilience
When we focus on inflation, we observe that there are new factors at play in the US that have the potential to keep wages rising and the labour market tighter than has historically been the case. We believe that it is in one significant area, the labour market, that there are worrying signs that slaying the inflation dragon might take longer and require more drastic action from monetary policy than is currently priced. Labour markets in many key economies remain concerningly tight. There is no doubt unemployment is a lagging indicator, however, there are structural factors at work that potentially point to labour markets remaining tighter for longer. These factors include labour hoarding, skills shortages, reduced labour market mobility, and declining immigration.
4. Tight labour markets headwind
Market volatility is likely to remain high. But perhaps the most important driver will be the fact that monetary policy across the globe will remain in restrictive territory for an extended period. With many central banks also embarking on quantitative tightening, liquidity will continue to be drained out of the system. This global tightening of financial conditions, at a time of slowing growth (even recessionary conditions) and rising default rates, will result in greater dispersion in macro conditions. Good policy making will be rewarded, bad policy making will be punished.
6. Quantitative tightening risks heighten
With uncertainty high, and crosscurrents buffeting the global economy, we are reluctant to take big-macro directional bets, but on balance are more disposed to back the Fed. In our global macro strategy, this makes us negative on the outcome for core rates and we are short US duration in the 10-year part of the curve. We are also cautious about risk in general and running credit and FX exposure close to neutral. At the current juncture, picking winners and losers at an idiosyncratic, bottom-up level makes more sense.
7. A bottom-up approach
Rising inflation and core rates have been the dominant driver of financial markets and asset performance this year. The combination of high and rising inflation, along with the sheer pace and magnitude of monetary and financial tightening through 2022, left investors with few places to hide. Core fixed income and credit experienced their largest drawdowns in modern history, and global equity markets are also down more than 15%. 2023 will be very different, with inflation falling, central bank policy rates peaking in the first quarter and the focus shifting to the trough in growth. In our view, 2023 will be a positive year for interest rate duration – yields on safe government bonds will fall – and for fixed income and high grade credit more broadly. Although risk assets typically rally following the end of central bank, and especially Fed, rate hiking cycles, this is likely to be short-lived as investors focus on the depth of the trough in economic activity.
Investment-grade credit could offer comparable yield to stocks, with less downside risk and volatility, predicts the team at RBC BlueBay
In the ‘lowflation’ era that preceded the pandemic, investors were forced into riskier assets, including equities, because bond yields were suppressed by zero rates and quantitative easing. But the sharp move higher in nominal and real bond yields has squeezed the equity risk premium – the difference between earnings yields and the yield on safe government bonds – to post global financial crisis lows. If our recession forecasts are correct, the equity risk premium will rise from current levels and, in our view, investment grade credit offers comparable yield to stocks, with less downside risk and volatility.
Note: Shaded columns denote NBER-dated US recessions. S&P500 year-on-year total return minus total return on BoA US Treasury index.Source: Macrobond; BoA; RBC BlueBay calculations; latest month November 2022.
Fig. 1: US Treasury yield curve regimes & relative performance S&P500 vs US Treasury index
Economic forecasts are rarely accurate (an understatement many would say) but we have high confidence in the direction of travel for growth and inflation through 2023. If inflation falls more slowly than forecast, the peak in central bank policy rates could be higher for longer, but we do not envisage rates peaking dramatically above current market pricing. Even in a stagflation scenario where high inflation is much stickier and rates stay high, intermediate and longer-dated bond yields are likely to rise only modestly. Unlike at the start of 2022, much higher initial yields will provide an income cushion for investors. In the positive scenario where growth holds up better than expected and inflation falls faster than forecast – a ‘goldilocks’ scenario – bonds will still perform positively in our view. Short term rates and bond yields will have peaked and be much less volatile, and investors will also benefit from the carry. In this scenario, investors will benefit rather than be punished by a positive correlation between bonds and stocks, although risk assets, including lower-rated credit, could out-perform core fixed income and high-grade credit. Equities have experienced double-digit drawdowns from their peaks, largely reflecting a re-rating lower of price-earnings (PE) multiples on the back of higher real rates. However, consensus forecasts will continue to assume mid-single digit earnings growth in 2023. Even without an outright recession, earnings growth is likely to disappoint as some of the decline in inflation will come from a squeeze on corporate profit margins.
“In this scenario, the correlation between bonds and stocks that was positive in 2022, when inflation was high and interest rates were rising, will switch back to negative”
In the falling inflation and recession scenario – our central case – the US Treasury curve will ‘bull steepen’ with yields across maturities falling, especially at the short to intermediate maturity (2-5yr) in anticipation of Fed rate cuts by more than yields on long-dated bonds (the orange line in Fig. 1). The correlation between bonds and stocks that was positive in 2022, when inflation was high and interest rates were rising, will switch back to negative. As we can see from Fig. 1, when the yield curve bull steepens, US Treasury bonds typically out-perform the S&P500 (the dark blue bars). Fixed income and high-grade credit will out-perform growth-sensitive risk assets, including high yield, in such a scenario.
Source: Macrobond; latest data at 21 November 2022.
Fig. 2: Shrinking equity risk premium
We expect ESG topics to continue to gain importance for issuers, investors and asset owners alike in 2023. Whilst the emerging markets fixed income asset class experienced significant outflows in 2022, ESG emerging markets hard currency funds actually recorded a net inflow – showing that investors were happy to finance ESG-aligned investments despite a difficult macroeconomic backdrop . This is encouraging, although much greater sums need to be directed towards emerging markets to close the USD 3.7trl funding gap in annual financing needed to reach the UN Sustainable Development Goals (SGD) by 2030, according to OECD estimates. On the regulatory side, scrutiny of ESG investment processes as well as fund labels (under SFDR regulation, established to standardise sustainable product classifications) remained in full force. Whilst we expect disclosure requirements for fund managers to continue to grow in 2023 with the implementation of SFDR 2, we don’t expect this to slow down the growth of AUM within this space.
“Investors are becoming more discerning about the quality of both Sustainability Linked and Use of Proceed bonds, and we expect this scrutiny to intensify”
Jana Harvey, BlueBay senior portfolio manager, emerging markets, RBC BlueBay Asset Management
There is a wide range of activity going on in the ESG space, among sovereigns and corporates alike, says Jana Harvey
We expect more innovative solutions this year to help emerging markets fund the mounting costs of climate mitigation and adaptation within their economies, amidst what is still likely to remain a hostile market environment for high yield names. In this respect, the COP27 agreement on the new “Loss and Damage” Fund for vulnerable countries has been a positive development and we are expecting details to be ironed out in the coming year. Finally, Indonesia followed the example of South Africa by announcing yet another Just Energy Transition Partnership at the G20 summit, helping the country to mobilize USD 20bn over the next 3-5 years to accelerate a just energy transition. We expect other countries to follow. Coming back to the liquid market solutions, this year will be interesting as following the quick rise of Sustainability Linked Bonds (SLB) issuance in recent years, Enel, the first issuer of such a structure, could see a coupon step-up in 2023, depending on whether it achieves its agreed KPI target. Last year was yet another milestone year for the SLB market as we saw the first sovereign SLB issuance from Chile, followed by the first sovereign SLB with a ‘step-up, step-down’ structure from Uruguay. This is a testament to the popularity of these instruments as well as innovation efforts from issuers to tailor them to their own needs. In this respect, investors are also becoming more discerning about the quality of both SLB and Use of Proceed bonds, and we expect this scrutiny to intensify. This should, in turn, result in higher performance differentiation amongst bonds, depending on the quality of the underlying structure. We are already starting to see more ambitious SLBs outperforming peers and within the UoP bonds, we expect EU Green bond standard aligned securities to see increased greenium/demand as investors look to increase alignment of their portfolios to European taxonomies.
Learn more about RBC BlueBay’s approach to emerging markets
Innovative funding for climate adaptation
Over the last year, we have also witnessed a step-up in engagement efforts, bilateral as well as coordinated, through organisations such as the EMIA, demanding greater transparency and improved ESG related disclosures to enhance the still very poor data sets within emerging markets. This effort is paying off, being met with more data as well as increased focus from the issuer side. Whilst we are still a long way from having a complete, standardised set of disclosures within our universe, this is a positive trend and we expect to continue to play our part in its advancement.
Step up in engagement
Issuers, meanwhile, are taking note of growing investor appetite, and we expect to see a continued pick-up in overall issuance as well as new entrants into the ESG-labelled bond market in 2023, within both the corporate and sovereign space. From the emerging markets sovereign side, we anticipate ongoing issuance from the well-established names, such as Chile, whilst others are expected to make a debut issuance in the year ahead with Turkey and Israel both completing their sustainable/green finance frameworks in preparation. Within the High Yield space, the Maldives are expected to return to the green bond market, whilst Gabon is expected to launch its first international green bond this year to fund the construction of hydroelectric plants. A number of countries at the earlier stages of their development are eyeing Debt for Nature swap solutions after Belize completed such a swap in 2021 in meaningful size, thus reducing its debt/GDP by 12%. Cabo Verde and Ecuador are presently in negotiations for similar arrangements and even Sri Lanka has been contemplating such a swap according to news reports. Other issuers are discussing a possible use of carbon credits in exchange for debt, creating carbon-backed bonds, but such solutions are still only in the discussion phase, given the early stages of the carbon market’s development.
Pickup in issuance
“We anticipate ongoing issuance from the well-established names, such as Chile, whilst others are expected to make a debut issuance in the year ahead”
1. Source: Morgan Stanley Research, Where supply meets demand, as at 9 December 2022.
We expect ESG topics to continue to gain importance for issuers, investors and asset owners alike in 2023. Whilst the emerging markets fixed income asset class experienced significant outflows in 2022, ESG emerging markets hard currency funds actually recorded a net inflow – showing that investors were happy to finance ESG-aligned investments despite a difficult macroeconomic backdrop . This is encouraging, although much greater sums need to be directed towards emerging markets to close the USD 3.7trl funding gap in annual financing needed to reach the UN Sustainable Development Goals (SGD) by 2030, according to OECD estimates.
2022 evidenced that rising interest rates present a challenge to frontier credits, requiring a diversification of external funding sources away from Eurobonds that many had become accustomed to. In 2023, as in 2022, this shouldn’t mean a systemic set of defaults, because idiosyncratic circumstances will play a large role in the ability of sovereigns to navigate the year and stay current on external debt. Factors such as proactive policy, terms of trade, depth of local markets and access to IMF resources should insulate almost all issuers in 2023. That is not to say that the market will not continue to price a heightened risk of debt distress, with focus on policy and external funding needs in 2023 and beyond, especially in twin deficit countries such as Kenya, Pakistan and Egypt where orthodox policy and adhering to IMF programs will be important drivers. Overall, for nations that regularly relied on relatively cheap Eurobond funding, fuelled by global liquidity, rising interest rates have seen many access IMF funding and begin to adjust policy to improve debt sustainability. Sovereigns such as Kenya have followed this path and have eased the burden for 2023. For issuers such as Sri Lanka and Ghana, the effect has been severe thanks to poor policy choices and proactively avoiding IMF policy prescription to access funding until it was too late. Sri Lanka defaulted, and Ghana will likely announce a debt restructure in order to belatedly secure IMF funding.
Christian Libralato, BlueBay portfolio manager, emerging markets, RBC BlueBay Asset Management
We expect the emerging markets high yield (EM HY) default rate to increase to 7.7% in 2023, but in order to understand the market impact, one must take a closer look. We expect by far the most defaults to come from China, Russia and Ukraine, driven by the property downturn in China, the war in Ukraine and associated sanctions. Having said that, most of these bonds trade on average around 30c, so defaults are largely priced in already and would not come as a surprise. Outside of these markets, our forecasted default rate is a benign 2.2%, which seems counterintuitive given higher funding costs and heightened recession risk. However, most EM corporates go into these challenges from a positive starting point, after a strong recovery post Covid and healthy aggregate leverage of 1.8x (JPMorgan).
Corporate credit
The strongest deceleration in profitability could be seen in commodity sectors, but again those benefitted from a particularly strong environment in the last 12-months and so have built buffers to withstand deterioration. And while in many major emerging markets growth is expected to slow in 2023, it will still stay positive. Regarding funding cost specifically, we don’t believe they will be of overriding importance for defaults in 2023 yet. Despite lower issuance in 2022, High Yield (HY) maturities due in 2023 have reduced and most companies have access to domestic markets for funding if international markets are not open to them. In addition, most of the EM corporate bond universe is in fixed coupons. And lastly, highly levered and financially engineered balance sheets are far less common in EM than in Developed Markets (DM) HY. And so average funding cost will increase rather gradually and not severely impact cash flows immediately. But higher rates will eventually have a more meaningful impact in the coming years. In any case, the above does not mean that there is no downside risk to default numbers as there remains uncertainty around the timing and severity of a recession, China’s Covid policies and further geopolitical tension, to name a few. In our downside scenarios, defaults rise to 13.4% and beyond. Still, while headline defaults will likely persist at elevated levels going forward, the amount of bonds trading at distressed levels is the highest in over 10 years and negative surprise risk is reduced.
In 2023, twin deficit nations will be most in focus. Pakistan has large external funding needs relative to reserves in an election year where policy choices may falter and challenge its ability to stick to its IMF program. Egypt will similarly face large external funding needs and its ability to continue policy adjustment to secure ongoing IMF and bilateral financing will be closely watched. Kenya needs to stick to its IMF program to continue to unlock external resources and avoid a similar fate to Ghana ahead of large external debt maturities in 2024. SSA Eurobond maturities in 2023 are relatively mild, easing the pressure somewhat on issuers who previously would look to market issuance to roll obligations. While 2023 may not see a stream of defaults, ongoing challenges will remain, and we observe that as debt maturities begin to grow in 2024-26, risks will be heightened should market issuance continue to be off the table at that time – however we note that is tail risk. Overall, we take a case-by-case approach to rising default risk in 2023 and beyond, with interest rates being one of the factors noted above. We observe that while there is a heightened risk of debt distress, much will depend on ongoing policy response and access to alternate funding, be it IFI or where bilateral relationships are key.
“We take a case-by-case approach to rising default risk in 2023 and beyond, with interest rates being one of the factors”
Source: J.P. Morgan
EM vs DM High Yield net leverage
Sovereign credit
Sven Scholzle, BlueBay senior corporate analyst, RBC BlueBay Asset Management
Andrius Isciukas, BlueBay portfolio manager, RBC BlueBay Asset Management
2022 evidenced that rising interest rates present a challenge to frontier credits, requiring a diversification of external funding sources away from Eurobonds that many had become accustomed to. In 2023, as in 2022, this shouldn’t mean a systemic set of defaults, because idiosyncratic circumstances will play a large role in the ability of sovereigns to navigate the year and stay current on external debt. Factors such as proactive policy, terms of trade, depth of local markets and access to IMF resources should insulate almost all issuers in 2023. That is not to say that the market will not continue to price a heightened risk of debt distress, with focus on policy and external funding needs in 2023 and beyond, especially in twin deficit countries such as Kenya, Pakistan and Egypt where orthodox policy and adhering to IMF programs will be important drivers.
Emerging markets had a tough year in 2022, driven by a combination of three main factors:
Polina Kurdyavko, Head of BlueBay Emerging Markets, RBC BlueBay Asset Management
In the Chinese year of the water rabbit, the outlook for EM is looking more positive, says Polina Kurdyavko
Yet, the rally is far from being secure or overdone. Given the high carry of the asset class (nearly 9% at the time of writing, the highest since 2009), we would expect the probability of a positive return from the EM hard currency sovereign index with a 12-month horizon to lie at 80%, with the mean return hovering around 9%. The outlook for long term investors holding onto this asset class for longer is even more attractive. Equally as important, we sense that the technical factors have a strong chance of turning positive in 2023, with multiple institutional investors on the sidelines looking to allocate to this asset class. Should these inflows materialise, spread tightening could be significant. Yet we would caution investors that “catching the bottom” may prove elusive, and indeed, further volatility cannot be discounted. The age-old approach of investing at attractive levels by small amounts and averaging out the overall investment should prove to be most rewarding. In summary, we acknowledge that 2022 was a shock, driven by a confluence of major unfavourable factors. But in our view, 2023, the year of the water rabbit according to the Chinese zodiac, should prove to be more prosperous, with some of the major clouds on the horizon lifting gradually.
“Russia’s withdrawal from Kherson, in our view, is the beginning of the end of this invasion”
Rising interest rates in the US. Resurgent economic activity following the depressed levels of the Covid era, and policy stimulus have led to higher CPI prints in the US, in turn causing a hawkish Fed to start an aggressively tighter monetary policy cycle. This has led to a stronger dollar and a net negative total return for many fixed income asset classes. Russia’s invasion of Ukraine. The ensuing war has resulted in a significant surge in commodity prices and triggered a nearly 40-year high in non-core inflation in many parts of the world, also contributing to further upward pressure on rates. Decimation of the real estate sector in China. Successive policy mistakes and strict credit tightening, as well as a stringent zero-Covid policy, had a material impact on Chinese GDP growth. As a result, we have witnessed a 2008 style sell off in the asset class, with an unprecedented amount of liquidity withdrawal (nearly $84bn as at end of October). The peak to trough drawdown in 2021-22 in emerging markets (EM) hard currency sovereign index has been 28%, which rivals the 29% sell-off we witnessed during the global financial crisis.
Yet at the height of this pessimism, we are also starting to notice some early hints of potential stabilising. In fact, the month of November provided some hope in that context. All three macro and idiosyncratic factors, described already, showed signs of turning:
US CPI print has come in lower than expected leading to a strong rally in US treasuries. Euro CPI is also starting to surprise on the downside. Russia’s withdrawal from Kherson, in our view, is the beginning of the end of this invasion and we now expect an end to this war, in one form or another, by the end of 2023. This has major consequence for the energy markets. In fact, most key energy and soft commodities are already materially below their peak. China appears to be more firmly seeking the path to reopen its economy and has developed a 16-point plan to support the property sector.
“We would caution investors that ‘catching the bottom’ may prove elusive”
It has been a tough period for investors. However, the case for investing in bank capital, particularly in liquid, well-run, well-managed and systemically important issuers, is strong. “Gone are the days of TINA (There Is No Alternative),” says Marc Stacey, Senior Portfolio Manager at RBC BlueBay Asset Management. “Because we have had a repricing in general risk assets, there is no need to go off-piste into illiquid or esoteric names. “Thinking about the average yield an investor gets on our BlueBay Financial Capital Bond Fund, it's currently around 9% in dollars. And that is with an asset that is quality-rated at single A, which are high-rated, very well-capitalised, and very liquid companies,” he says.
The banking sector: a sweet spot in credit markets?
In an era of high interest rates, investment grade banks look well placed to offer safe, attractive yields, according to Marc Stacey
There are a few other fundamental metrics that investors can take comfort from. Banks have better liquidity provisioning, including better matching of their assets and liabilities. They also have better liquidity coverage ratios, a measure which shows how much cash or government bonds they have on their balance sheets that they can sell down to meet their obligations. Another strength is how few non-performing loans are currently sitting on the books of the banks. “This measure is at historic lows at just about 2%,” says Stacey. “Over the last 10 years, banks have cleaned up their balance sheets and disposed of non-performing loans in many regions. So, the starting point as we go into what is inevitably going to be another recession is with asset quality in very good shape and with non-performing loans at a very low rate,” he says. Stacey adds that the business of banks is different than it was back in 2007/2008, when we entered the global financial crisis. “One of the consequences of what we underwent was that the regulator has been very quick to assign much higher capital charges for riskier businesses,” he says. “For example, proprietary trading desks at banks are a fraction of the size they used to be in 2007/2008. Today, banks' business models are far more aligned on net interest margins, advisory, brokerage and asset management,” he says. That has had consequences for equity multiples, but is great news for bonds investors and in particular subordinated bond investors who are lower down the capital structure. “On the one hand the businesses are safer and more utility-like but on the other hand the fundamentals have improved meaningfully, both from a bottom-up perspective with more capital, more liquidity, and better balance sheets,” he says.
Banks looking strong on other indicators
Asset quality is important in an environment where the US Federal Reserve and other major central banks are tightening financial conditions. Rate hikes heighten recession risk and therefore the possibility of issuers failing. “Default rates are at historic lows but will likely move higher, because tighter financial conditions mean that not all sectors and not all companies are going to make it,” says Stacey. This makes it paramount for investors to invest in best-in-class issuers that are likely to stay solvent in an environment of higher interest rates, he adds. As Europe and the UK head into recession, the banking sector offers that safety thanks to the equity buffer that has been built up over the last 10+ years as regulators have forced banks to hold more capital.
Minimising default risk
Find out more about the BlueBay Financial Capital Bond Fund
A structural investment opportunity
March 2023
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MArketing COmmunication
“Investment grade banks are starting from strong fundamentals here,” explains Stacey. “If we think about how much capital was lost during the 2007/2008 financial crisis, it was around 6% on average. If you think about what has been added since then, about 9%, then you have got almost 1.5 times the capital that was lost during the global financial crisis now sitting on banks' balance sheets. “That's a reason why we think that this asset class and particularly European bank Additional Tier 1 bonds (AT1s) within the banks' capital structure represents a sweet spot, because you're achieving these high yields in these higher rated issuers.”
“You have almost 1.5 times the capital that was lost during the global financial crisis now sitting on banks' balance sheets”
“Our expectation in Europe is that we've still got between 50 and 100 basis points of interest rate hikes to come”
Finally, as Europe moves from a negative interest rate environment to a positive one, that tailwind from a profitability standpoint is very good for banks' bottom line. “Our estimates are that every 25 basis points parallel shift upwards in the yield curve translates to about 3% or 4% uplift in banks' profitability,” says Stacey. “Our expectation in Europe is that we've still got between 50 and 100 basis points of interest rate hikes to come. So it's a sector that's still going to benefit hugely from the interest-rate tailwind and profitability,” he says.
Interest-rate tailwind
At times, the market for investment grade bonds or high yield bonds may dry up, which could make it difficult to sell these bonds, or the fund may only be able to sell them at a discount There may be cases where an organisation with which we trade assets or derivatives (usually a financial institution such as a bank) may be unable to fulfil its obligations, which could cause losses to the fund Investing in subordinated bank debt, including CoCos, offers you the chance to gain higher returns through growing your capital and generating income. Nevertheless, there is a risk that CoCos may 1) be converted to equities or permanently written down 2) not be redeemed by the issuer when expected 3) defer or cancel interest payments indefinitely, which would result in a loss of income to the fund and possible loss of its initial investment. Additionally, CoCo investors may suffer losses prior to investors in the same financial institution holding equities or bonds BlueBay's ESG analysis can rely on input from external providers. Such data may be inaccurate or incomplete or unavailable and BlueBay could assess the ESG risks of securities held incorrectly BlueBay could suffer from a failure of its processes, systems and controls – or from such a failure at an organisation on which we rely in order to deliver our services – which could lead to losses for the fund
Risk considerations
• • • • •
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed.
Source: EBA, RBC BlueBay Asset Management, as at 30 December 2022. For illustrative purposes only. There is no assurance that any of the trends depicted or described herein will continue.
Banks have more equity sitting on their balance sheets
Marc Stacey, BlueBay Senior Portfolio Manager, Investment Grade at RBC BlueBay Asset Management
“You should always have an active manager in this space, because you want to avoid any issuers that may run into trouble”
To some extent, risk assets have been a mirror of what we experienced in 2022, with the market environment being supportive in 2023. That's been due to a combination of spreads tightening and also government bond yields moving a bit lower from the highs we saw in October last year. Inflation has been moving lower and so there has been the expectation that central banks don’t need to be so aggressive.
There's a lag before interest rate rises start to filter through into the real economy. So, we would expect the tighter financial conditions that have been introduced by central banks to begin to bite towards the second half of this year. From there, it's a fine line between a soft landing versus a hard recession. We could say that a harder recession is less likely today than we were expecting in the later stages of 2022, but you still want to be in sectors that have the fundamentals to hold up.
As for the rest of the year, what are the chances of a hard landing and how do investors navigate the uncertainty?
Part of the reason why European banking AT1 has strong fundamentals but still trades at elevated yields and spreads is because it doesn't feature in either the high yield or the investment grade indices. This, along with the rise of passive investing and ETFs, means you have an asset class that's fallen through the cracks. Unless you are constrained by having to be in a benchmark or invest in indexed securities, there's a huge opportunity, which is why we launched this fund back in 2015. That doesn’t exist with US preferred stocks, for example, where there's a huge retail element. You get tax incentives for buying US bank prefs so they don’t trade with the same discount.
The valuations allow us to reduce our credit risk. If you look at the average issuer rating in our fund, it's single A. We invest in the best-in-class national champions in each region. These are the ones that are well-capitalised, highly liquid, well-managed and profitable. You've got this huge buffer from a credit fundamentals perspective, whether it be capital or liquidity, and yet you're still being paid these elevated spreads because of the lack of inclusion in indices. Our investment process is driven very much from a bottom-up perspective, making sure that those credit metrics that we think are important, like capital, liquidity and access to capital markets, are highly prioritised for us. And if we get the right bank and call correct, then we can afford to move down the capital structure, out of senior or lower tier 2 and into AT1, where we are picking up close to 300 basis points versus lower tier 2.
What do these elevated valuations mean for the amount of risk you take on?
The economic outlook may be uncertain but subordinated debt instruments such as CoCos are well placed to weather the storm. In this Q&A, Marc Stacey reports on how the market has performed so far this year and why valuations continue to be attractive
Part of the reason why European banking AT1s have strong fundamentals but still trade at elevated yields and spreads is because they don't feature in either the high yield or the investment grade indices. This, along with the rise of passive investing and ETFs, means you have an asset class that's fallen through the cracks. Unless you are constrained by having to be in a benchmark or invest in indexed securities, there's a huge opportunity, which is why we launched the BlueBay Financial Capital Bond fund back in 2015. That doesn’t exist with US preferred stocks, for example, where there's a huge retail element. You get tax incentives for buying US bank prefs so they don’t trade with the same discount.
Why are valuations in European banking Additional Tier 1 bonds (AT1s) so structurally attractive?
How has 2023 been for the BlueBay Financial Capital Bond Fund so far?
“We would expect the tighter financial conditions that have been introduced by central banks to begin to bite towards the second half of this year”
“You should always consider an active manager in this space, because you want to avoid any issuers that may run into trouble”
You're always going to have some divergence across different regions because you'll have different factors. For example, Italian banks might diverge to some extent from French banks because of the political uncertainty that you have there. Then there are also macro and micro factors that will influence the trading and spread levels of the various banks within those regions. That’s part of the reason why we think you should always consider an active manager in this space, because you want to avoid any issuers that may run into trouble. Yes, it's a sector that has improved its resilience meaningfully over the last 20 years, but equally, the idea that governments and taxpayers will bail you out if you're in the wrong bank is no longer applicable after the Lehman Brothers collapse and the regulatory reform that we've had. If you're invested in the wrong bank, it doesn't matter whether you're in AT1, lower tier 2 or even senior non-preferred, you're likely to see losses. We saw this with Banco Popular when it was recapitalised in Spain. So, it requires an active manager doing the due diligence and bottom-up credit research. If you do that, then you can take advantage of the elevated yields and spreads and give yourself the best chance of avoiding the banana skins.
There have been significant divergences in issuer performance so far this year. Why is that?
What are CoCos?
Contingent convertibles (CoCos) are debt instruments usually issued by European financial institutions. They were designed after the 2008 financial crisis to act as shock absorbers if a bank runs into trouble and sit within Additional Tier 1 (AT1) of the Basel Committee’s capital standards. They protect banks through a variety of mechanisms. CoCo coupons might be suspended, or CoCo debt might be converted into equity or written off if certain triggers are reached, for example if the bank’s core Tier 1 capital falls below a given ratio. In return for accepting this risk, investors are paid relatively generous coupons. RBC BlueBay believes that a gap has opened up between the high yields available from CoCos and an apparent reduction in risk as banks have built up their balance sheets.
There's a lag before interest rate rises start to filter through into the real economy. So, we would expect the tighter financial conditions that have been introduced by central banks to begin to bite towards the second half of this year. From there, it's a fine line between a soft landing versus a hard recession. We could say that a harder recession is less likely today than we were expecting in the later stages of 2022, but you still want to be in sectors that have the fundamentals to hold up. In this respect, we think the profitability tailwind that banks are receiving from rising interest rates and increasing net interest margins will offset the headwind of deteriorating asset quality and increasing cost of risk. That's when you will start to see the rate-sensitive sectors really differentiate, with banks being benefactors and other sectors being impeded by those higher rates.
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How has 2023 been for you so far?
You're always going to have some divergence across different regions because you'll have different factors. For example, Italian banks might diverge to some extent from French banks because of the political uncertainty that you have there. Then there are also macro and micro factors that will influence the trading and spread levels of the various banks within those regions. That’s part of the reason why we think you should always have an active manager in this space, because you want to avoid any issuers that may run into trouble. Yes, it's a sector that has improved its resilience meaningfully over the last 20 years, but equally, the idea that governments and taxpayers will bail you out if you're in the wrong bank is no longer applicable after the Lehman Brothers collapse and the regulatory reform that we've had. If you're invested in the wrong bank, it doesn't matter whether you're in AT1, lower tier 2 or even senior non-preferred, you're likely to see losses. We saw this with Banco Popular when it was recapitalised in Spain. So, it requires an active manager doing the due diligence and bottom-up credit research. If you do that, then you can take advantage of the elevated yields and spreads and give yourself the best chance of avoiding the banana skins.
Recent times have been interesting for environmental, social and governance (ESG) or responsible investing (RI), to say the least. The optimists out there would point to the continuing mainstreaming of ESG into financial markets and its infiltration into the wider societal consciousness. There has also been an increased focus on biodiversity. But the Russia/Ukraine war has resulted in an energy crisis, potentially hindering efforts to mitigate climate change. The global UN conference (COP27) failed to live up to the expectations. And concerns about the validity of ESG claims (so called ‘greenwashing’) came to the fore, feeding into broader scrutiny of ESG/RI investing itself. So where do we go from here? There are seven key themes and trends facing the ESG world as we continue to progress through what has been called the ‘Decade of Action’.
Social change? Regulation beyond Europe? Active stewardship in the spotlight? In this article, My-Linh Ngo summarises some of the key issues on the agenda for responsible investment as we move forward
Read further insights from RBC BlueBay here
An active approach to investing
My-Linh Ngo, Portfolio Manager and Head of ESG Investment at RBC BlueBay Asset Management
The world needs to continue tackling climate change. This means refocusing back on the energy transition. The COP28 global stock-take UN conference later this year needs to be a direct trigger for raised ambition for governments which will also feed into continued corporate efforts. In addition to decarbonisation, there should be more activity around the themes of climate financing, adaptation and ensuring a just transition in emerging markets and for vulnerable communities globally.
1. Getting climate change back on track
Expect to see companies, financial institutions and governments talk more – and take more steps – on nature and biodiversity. This will include deforestation most visibly and see increasing emphasis on ‘natural-based’ solutions. Many commitments and actions covering disclosure, data and analytics have been in development over the past couple of years, informed by efforts to address climate change, allowing action to be scaled up faster.
2. Nature and biodiversity – now firmly on the agenda
Governments face increasingly difficult trade-offs between supporting vulnerable households in the wake of the cost-of-living crisis and addressing their debt burden following Covid-19. We have already witnessed social unrest with worker strikes across the public sector. Meanwhile, the Russia/Ukraine war has strained global supply chains, putting corporate financial sustainability at risk. All of this will play out in the investment world, with scrutiny of how issuers are responding to these challenges and managing them.
3. The ‘S’ of ESG – increased social and political unrest
Whilst European ESG regulatory developments continue to dominate much of the headlines, this year we expect a further broadening of geographical focus. The US and UK, among others, are expected to define their ESG regulatory framework for the ‘what’ and ‘how’ of ESG/RI investing. The hope from companies and financial institutions is that there will be a harmonisation and standardisation of ESG approaches across the different jurisdictions. But whilst we may see some of this happen, the reality is that the regulatory landscape will likely continue to be fragmented, making it challenging for global firms to operate.
4. ESG regulation – ever more detailed, but will it deliver?
Active stewardship will move further into the spotlight. With investors being scrutinised on the ESG credentials of their holdings, expect them to increase their interrogation of issuers’ ESG efforts. Regulations, as well as wider efforts to address ESG and sustainability impacts, will continue to drive the demand for data and analytics to help stakeholders (including investors) better understand risk exposure as well as performance outcomes.
5. Increasing focus on stewardship activities
With greater scrutiny of the investor’s portfolio ESG credentials, we could start to see ESG impacting an issuer’s ability to tap markets for funding, and/or increase the cost of doing so, in a notable way. If we do, and the rubber starts to hit the road, then the market will see clearer differentiation of issuers on ESG grounds.
6. ESG reputation/performance starting to matter?
Last year saw the legitimacy and credibility of ESG and RI approaches being questioned in some circles, as well as increased politicisation. Increased ESG regulations have contributed to this scrutiny, as they have added a level of technicality and highlighted the complexity of how ESG/RI can be applied. This theme will continue to play out in the market. Whilst debate and reflection are to be expected and welcomed, this needs to be conducted constructively and not conflated with other matters. Rising above the noise, the ESG/RI industry needs to ensure it is transparent and responsible in its conduct.
7. ESG itself will remain in the spotlight
“The regulatory landscape will likely continue to be fragmented, making it challenging for global firms to operate”
It has been an encouraging start to 2023 in terms of returns, engagement and activity for high yield. A drawdown of -11.38% in 2022 has set the stage for better returns over the next 1-2 years in this strongly mean-reverting asset class. The sharp repricing of government bond yields has taken the yield on global high yield to nearly 8.6%, which is a good entry point for longer-term investors based on history. The challenge for allocators, however, is that greater opportunity is not without risk. Higher interest rates over several quarters tend to lead to defaults due to pressure on corporate earnings and profit margins. The challenge to cash flows from a regime change on funding costs is that they will take a long time to play out. With limited maturities and largely fixed coupon debt, this is a multi-quarter or even multi-year process. However, it can also be costly to sit on the sidelines waiting for lagged quarterly data to confirm that most high yield companies have weathered the storm. Global high yield is among the most resilient asset classes and tends to rebound quickly after a drawdown, thanks to its consistent, high income.
Claudio Da Gama Rose, BlueBay Institutional Portfolio Manager, Leveraged Finance, at RBC BlueBay Asset Management
The quality of fundamentals and technical factors gives us confidence that global high yield can bounce back quickly, says Claudio Da Gama Rose
“The higher the coupon, the more able the bond is to absorb any decline in dollar price”
Since total returns are the price moves of a bond plus coupon payments, the higher the coupon, the more able the bond is to absorb any decline in dollar price caused by a rate or spread hike. When high-yield issuers call their bonds before they mature, they pay bondholders a premium for the privilege. And bonds do not typically default – if they can be refinanced and with higher yields, there is more incentive for capital to be provided to management companies to refinance their bonds. Outside of public bond markets, management companies can also refinance global high yield bonds in the private credit, leveraged loan, convertible bond or equity markets.
Why is global high yield resilient?
The underlying credit ratings for the asset class have been on an improving trajectory. Around 58% of the global high yield index is now in the top rated BB cohort. Trailing credit metrics reflect that there has been material deleveraging over the past few years, with US high yield bond leverage now below 4x. For some industries, the inflation shock has been credit positive, enabling them to pay their fixed-rate obligations with inflated assets and cash flows.
Fundamentals – a strong starting point eases concerns
“The supply of US high yield was significantly below the average for the decade”
High yield supply has been exceptionally low. The supply of US high yield was only USD 115 billion last year, which is significantly below the average for the decade, at an 80% drop. And particularly for new deals and clean stories, there is very strong demand in this market. Primary market issuance is only expected to be slightly higher in 2023 and represents an attractive channel to re-position portfolios. It is the same story in Europe. This meagre supply means that credit spreads have been tighter, pushing high-yield bond prices higher. Last year there were sizable outflows from the asset class, and we are seeing evidence in recent fund flow data that this trend is beginning to turn.
Technical factors remain supportive
It may be premature to say we have reached peak yields in this global high yield cycle until we have a few more quarters of earnings releases. But we believe that yields at nearly 8.6% are sufficient to compensate investors for foreseen and unforeseen risks. In past cycles, global high yield has delivered positive returns despite rising credit stress and weakening growth rates. The starting quality of fundamentals and strong technical factors give us the conviction that the asset class can continue its mean reverting pattern, after a rare down year.
Key takeaways
The underlying credit ratings for the asset class have been on an improving trajectory. Around 58% of the global high yield index is now in top rated BB cohort. Trailing credit metrics reflect that there has been material deleveraging over the past few years, with US high yield bond leverage now below 4x. For some industries, the inflation shock has been credit positive, enabling them to pay their fixed-rate obligations with inflated assets and cash flows.
High yield supply has been exceptionally low. The supply of US high yield was only USD 115 billion last year, which is significantly below the average for the decade, at an 80% drop. And particularly for new deals and clean stories, there is very strong demand in this market. Primary market issuance is only expected to be slightly higher in 2023 and represents an attractive channel to re-position portfolios. It Is the same story in Europe. This meagre supply means that credit spreads have been tighter, pushing high-yield bond prices higher. Last year there were sizable outflows from the asset class, and we are seeing evidence in recent fund flow data that this trend is beginning to turn.
The energy and metals and mining sectors have seen the most impressive credit metric improvements over the past few quarters. The most indebted segments of the investment universe offer higher spread but with additional risk on how their upcoming maturities will be refinanced. As underwriting standards tighten, industries in secular decline, such as some pockets of broadcasting and retail, will also warrant careful due diligence to identify the survivor balance sheets and avoid the capital structures heading towards a restructuring/default scenario. While we expect defaults to rise in 2023, companies do have more breathing room than in prior recessions. The tailwind of the Covid era is that companies had ample time to refinance upcoming maturities. And we expect that the limited near-term maturities over the next 12 months will keep a lid on defaults.
For some years now, sustainable investors have been recognising the importance of water as an investment theme. Indeed, it is included as one of the seven People and Planet themes in BlueBay's Impact-Aligned Bond Fund. But the drought across Europe last year and the high-profile sewage leaks in the UK since 2021 have only emphasised the importance of good water management and stewardship. To coincide with World Water Day, here’s a summary of the latest developments and what they mean for investors.
Robert Lambert, BlueBay Portfolio Manager, Investment Grade
Recent events have brought home the importance of addressing issues around water. In this article, Robert Lambert discusses the considerations for investors
Learn more about the strategy
Ensuring clean and plentiful water is one of the seven investment themes within our Impact-Aligned Bond strategy, a sustainability-focused, thematic public debt strategy that allocates capital to ‘solution providers’ – companies that make a difference today by addressing the problems of tomorrow.
“It is not just the UK that is facing issues around water leakage and pollution”
Last summer’s heatwaves led to Europe’s worst drought in 500 years . Along with causing wildfires and forcing the introduction of water usage restrictions, the drought had serious implications for energy production, exacerbating already high prices for electricity and gas. Most obviously, it reduced the availability of hydropower. Low water levels in reservoirs meant monthly hydro production in the EU fell below solar power for the first time in July 2022 . However, it was not just hydropower that was affected. EDF was forced to cut its output at nuclear power stations on the Rhône and Garonne rivers due to a lack of river water to cool the reactors , while German power plants warned of a coal shortage as shipping was disrupted on the Rhine . As investors, we not only need to monitor which issuers are most exposed to these effects, but also which are taking the steps to develop and adopt solutions. For example, the solution for nuclear is alternative cooling methods such as 1) air-cooling systems or 2) closed loop systems where the same water is circulated continuously.
Drought and its impact on energy production
Our discussions with various international water companies reflect that it is not just the UK that is facing issues around water leakage and pollution. In the US, for example, many cities and water systems have ageing pipes and infrastructure. The American Society of Engineering gave the country’s drinking water infrastructure a D grade in its 2021 report card. Equally, in many developing countries, access to clean water and sanitation is a massive challenge. But there’s no doubt that the issue has risen in salience in the UK. In 2021, allegations emerged that some UK water companies were illegally discharging untreated sewage into rivers.
UK sewage scandals and their fallout
“We see a bounce back this year. The US corporate bond market looks quite rich and there’s a much bigger opportunity in European bonds”
So more broadly, how has water as a theme been performing? European water names have largely moved in line with the European market for corporate bonds, which suffered in 2022 due to the first-hand impact of the Russian invasion of Ukraine on energy markets, supply chains and cost inflation. While European water companies have been partially insulated from these challenges given they purchase a significant portion of their energy through long- term, fixed-price contracts, there has still been near-term pressure given the magnitude of the move. Energy costs have doubled on average, which is material when they typically account for around 10% of the cost base. Outside of Europe, US and emerging market water companies have fared better given a less direct impact on energy prices. The US, for example, enjoys energy independence, with plentiful supplies of gas and a better functioning electricity market. The US Federal Reserve also acted quicker on inflation than the European Central Bank. Overall, we see a bounce back this year. The US corporate bond market looks quite rich and there’s a much bigger opportunity in European bonds now.
Performance as an investment theme
Controversy has continued with sewage being washed up on numerous beaches around the country. Within the first four days of 2023, 328 water pollution alerts had been issued around the British coastline . The BlueBay fixed income investment team has been engaging with the UK’s water companies since the allegations first emerged. We’ve taken a best-in-class approach by investing in the two UK water companies that we believe to have most progressive practices: Severn Trent and Northumbrian Water. Both lead the field in innovation and environmental performance, receiving the maximum four stars in the Environment Agency’s 2021 performance metrics.
At times, the market for investment grade bonds may dry up, which could make it difficult to sell these bonds, or the fund may only be able to sell them at a discount There may be cases where an organisation with which we trade assets or derivatives (usually a financial institution such as a bank) may be unable to fulfil its obligations, which could cause losses to the fund BlueBay's analysis of sustainability factors can rely on input from external providers. Such data may be inaccurate or incomplete or unavailable and BlueBay could assess the sustainability risks of securities held incorrectly BlueBay could suffer from a failure of its processes, systems and controls – or from such a failure at an organisation on which we rely in order to deliver our services – which could lead to losses for the fund
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This document is a marketing communication and it may be produced and issued by the following entities: in the European Economic Area (EEA), by BlueBay Funds Management Company S.A. (the ManCo), which is regulated by the Commission de Surveillance du Secteur Financier (CSSF). In Germany, Italy, Spain and Netherlands the ManCo is operating under a branch passport pursuant to the Undertakings for Collective Investment in Transferable Securities Directive (2009/65/EC) and the Alternative Investment Fund Managers Directive (2011/61/EU). In the United Kingdom (UK) by BlueBay Asset Management LLP (BBAM LLP), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and is a member of the National Futures Association (NFA) as authorised by the US Commodity Futures Trading Commission (CFTC). 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1. bbc.co.uk 2. spglobal.com 3. theguardian.com 4. reuters.com 5. independent.co.uk
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Last summer’s heatwaves led to Europe’s worst drought in 500 years . Along with causing wildfires and forcing the introduction of water usage restrictions, the drought had serious implications for energy production, exacerbating already high prices for electricity and gas. Most obviously, it reduced the availability of hydropower. Low water levels in reservoirs meant monthly hydro production in the EU fell below solar power for the first time in July 2022 .
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If last year proved anything, core fixed income is not always boring. A 16% drawdown is severe, but in the context of the asset class, it represented 4.5 times the usual volatility (or a once in 400,000 years event based on expectation) and the worst return on record. This may not sound encouraging; however, it also represented a significant, and much needed, reset to yields (Chart 1). It undid years of quantitative easing and rate cuts that had left the asset class languishing as just a risk diversifier in investor portfolios. Today, investors can exploit their fixed income allocation much more, making 2023 a prime opportunity to revisit approaches in this space.
David Horsburgh, Head of Client Solutions, RBC BlueBay Asset Management
Low yields encouraged the rise of passive investing but there is now significant opportunity for excess return in fixed income, says David Horsburgh
April 2023
“A strategy that targets 150bps of alpha can deliver this same return three times in just over two years”
A consequence of low yields was a commoditisation in the form of a shift to passive for some investors. As yields fell, the starting expectation for returns was lowered, and alpha capture was deprioritised versus hygiene factors such as achieving portfolio diversification and reducing fee drag. Macro tailwinds, in the form of falling yields, and bond buying programmes meant that simple beta exposure was all that most wanted to achieve. This period was also characterised by low volatility, considering quantitative easing’s suppression of risk, and more weight was given to private markets and growth equity in terms of active bets. With higher yields, there is an opportunity and rationale to reverse some of this. Passives provide a useful tactical way of adding exposure quickly, but in fixed income the approach can have significant drawbacks. An important distinction between bonds and equity is that, while equity weights are driven by the biggest businesses (or market cap), fixed income flows to the most indebted (biggest issuers). As the economic cycle changes to one of weakening growth and quantitative tightening, this leaning to expanding areas of debt can create unintentional skews to benchmarks, which an active manager can position against. One example of this is the large weight to BBBs within investment grade indexes (39% for the Barclays Global Aggregate at the end of December 22) – an area where you could see the most price movement as underlying fundamentals change and re-ratings occur. Passive still has a role for investors, especially over the short term, but longer term there is a significant opportunity cost for those that leave potential alpha on the table.
Off the shelf
The yield (YTM) on the Bloomberg Global Aggregate is currently hovering around 3.8%. This is more than double what it was this time last year. While this might satisfy some investors, a strategy that targets 150bps of alpha can deliver this same return three times in just over two years. The cumulative effect of incremental increases to returns can have a large impact on portfolios over multi-year cycles. That said, as we’ve seen recently, fixed income can be a source of uncertainty. The current environment is one with heightened dispersion between names, and an uncertain path for rates with some disagreement between markets and central bank forward guidance (Chart 2). While this may create a headwind for a passive allocation, this is an environment that provides an increased opportunity set for the active investor – provided you have the right tools or approach.
Three for the price of two
Beneath its dull and somewhat simple appearance, there are several levers that an active manager can use to create alpha in fixed income. This is not just a matter of holding, or not holding, issues. Even within simple approaches, you can:
Under the bonnet
The goal is always to beat the benchmark with a bounded tracking error, but using tools such as derivatives to manage risk should be front and centre of any strategy. These allow investors to maximise their flexibility and reorientate and adjust the portfolio without churning in and out of individual issues. Given the spread between bid and offer in the asset class, sensible trading can help crystallise gains, whereas creating churn passively can often create unnecessary hurdles in terms of achieving your return objective
Chart 1: In 12 months the yield on offer has improved across the board
Source: Bloomberg Global Aggregate Bond Fund, 31/12/22.
Chart 2: The gap between central banks and markets
Source: Bloomberg, as at 28/02/23, FOMC dots as at 14/12/22.
Adjust maturity and change duration; Take, or isolate, risk in the currency/interest rate/credit risk of individual bonds; and Create shifts in credit quality to change the sensitivity of your portfolio to different inputs.
The opportunity here exists because fixed income is an asset class where several different idiosyncratic factors can be at play at any given time. These range from macro events like rate changes and data releases, upgrades and downgrades, and liquidity issues in the market, all seen through a lens of heightened volatility (Chart 3).
Chart 3: Sharp increase to fixed income volatility
Source: ICE BofA Move Index - end Feb 2023 (Index tracking volatilityof treasury options).
Chart 3: Sharpe increase to fixed income volatility
In recent years, much attention has been placed on addressing deforestation. But while important, we believe attention and action also needs to be directed towards our marine and freshwater ecosystems – oceans, seas, coasts, lakes and rivers. The ‘blue economy’ is a term which has emerged in recent years to describe the sustainable use of ocean and freshwater resources for economic growth, improved livelihoods and jobs. We believe that sustainable freshwater and marine management is critical in maintaining a stable climate. According to a study published by NOAA (National Oceanic and Atmospheric Administration), the ocean acts as a ‘carbon sink’ and absorbs about 31% of the CO2 emissions released into the atmosphere.
My-Linh Ngo, BlueBay Head of ESG Investment, Portfolio Manager, RBC BlueBay Asset Management
My-Linh Ngo discusses the importance of the blue economy in building a sustainable future and the role of public debt markets
“The recognition of nature and biodiversity as systemic risks saw them become the breakthrough ESG theme of 2022”
In 2020, BlueBay selected the Blue Marine Foundation (Blue Marine) as one of our corporate charity partners. Blue Marine is dedicated to restoring the ocean to health by addressing overfishing and campaigning for the protection of at least 30% of the ocean by 2030. Our donations have helped set up BLUE Economics, a specialist team within Blue Marine. It is quantifying the true value of the blue economy and the cost of overfishing, as well as developing new ways of directing capital at scale towards ocean protection and restoration. Investing in the blue economy is also an area that features within our planet theme named ‘enabling a circular economy’. To date the investable opportunities have been limited in terms of the issuers that would qualify. However, we believe the emergence of the ESG-labelled bond market presents a potentially important opportunity for fixed income investors to uniquely support corporates and sovereigns, supranationals and agencies (SSAs), where so called ‘blue bonds’ could channel capital to such purposes.
Our ‘blue’ credentials
Continuing to engage and work with organisations and initiatives like Blue Marine, alongside others, will be important in building momentum and action on protecting our oceans and ensuring economic and social prosperity. A tailwind is that nature and biodiversity are now firmly on the agenda. The recognition of nature and biodiversity as systemic risks and their interconnectedness to climate change saw them become the breakthrough ESG theme of 2022. In 2023, we expect to see companies, financial institutions and governments talk more – and take more steps – on nature and biodiversity. We believe that ESG considerations continue to be an important driver of long-term investment returns from both a risk mitigation and opportunity perspective. And beyond this primary driver, incorporating ESG into investment practice may have the ancillary benefit of contributing to safeguarding our common future.
Building momentum
Equity buyers have traditionally been the ones engaging with companies. As shareholders – and therefore part owners of the business in question – they enjoy proxy voting rights, which give them the opportunity to influence corporate governance and directly engage with management teams on how the company is run. Bondholders are lenders, not owners, and do not have a direct legal mechanism of influence. But the importance of ESG in the investment community has changed this dynamic, unlocking the bondholder’s voice. What bondholders lack in voting rights, they make up for in size and therefore potential ability to influence. As individuals or a collective, bondholders have the power to financially back or withdraw support for new issuance, with the associated ability to drive up borrowing costs. In the past, if one bond investor skipped an issue on ESG concerns, another would likely buy the bonds, maintaining demand. But as ESG factors become central to clients’ mandates, the industry as a whole is shifting towards a more scrupulous operating model. Poor ESG practices are becoming less tolerated. A company with little regard for ESG considerations could be met by a lukewarm appetite for its issuance, with those who are willing to buy the debt pushing up the cost of borrowing to compensate for heightened ESG risks.
Lucy Byrne, BlueBay Senior ESG Analyst, ESG Investment, RBC BlueBay Asset Management
As ESG becomes more important, bondholders are using their size to back or withdraw support for issuers, says Lucy Byrne
Learn more about the RBC BlueBay’s approach
“Collaborative engagement can offer a powerful mechanism for debt investors to influence issuers”
Driving change is rarely easy, meaning bond and equity holders alike face challenges in getting their voices heard. Within fixed income, there are many nuances that can shape how effective engagement methods are – some represent potential roadblocks, others opportunities.
Engaging with different types of issuer
Collaborative engagement can offer a powerful mechanism for debt investors to influence issuers on improved ESG practices. These can be broad or specific, with a collective often having more sway than individual efforts. We are members of numerous industry bodies and initiatives in order to inform and develop our internal ESG practices and to advance ESG thinking across the fixed income investment universe.
Collaborative ESG engagement
“There can be more barriers and challenges to engaging with sovereigns than with corporates”
There can be more barriers and challenges to engaging with sovereigns than with corporates. The focus of sovereign engagement is typically to generate insights, but there can be opportunities to engage for influence, such as improving fiscal transparency and ensuring an operating environment that gives investors confidence.
Corporates vs. sovereigns
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It can be easier to engage with investment-grade issuers than with high yield ones, as they are typically larger and have greater resources. This increases their ability and need to engage on topics such as results. Engagement with high yield issuers can be helpful in terms of generating insights and better understanding ESG practices and risk management, particularly when there is a lack of third-party data available and limited public disclosure.
Sub-asset class differences
Gaining access to emerging market (EM) issuers can be a challenge, both for corporates and sovereigns. Engagement with EM issuers can be particularly useful in understanding ESG practices where disclosure is weak, as well as to drive positive change and best practices.
Emerging vs. developed markets
Engagement is possible in securitized credit but the nuances of the asset class mean careful consideration must be applied to the methods used, the level at which engagement is possible (e.g. with the manager) and the degree to which there can be engagement for influence purposes (as opposed to purely for insight).
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Conventional public debt vs. securitized credit
The aim of our engagement is to encourage policymakers in Brazil, at federal and state level, to make greater progress in tackling deforestation in the Amazon and other key biomes. Since July 2020 we have been co-chair of the Investor Policy Dialogue on Deforestation (IPDD), a global collaborative investor engagement initiative which aims to highlight to sovereign issuers the dangers of failing to tackle forest loss. We also lead the IPDD’s Brazil work stream, and are refocusing our approach away from persuasion of a sceptical Bolsonaro administration to encouragement of a much more sympathetic Lula government. We revised our Investment ESG Score for the Brazil sovereign up from -2 to +1 (on a scale of -3 to +3) in January following the inauguration of Lula as President. Although he will need to negotiate from a position of weakness in Congress, Lula’s policy instincts will be markedly more ESG-friendly than his predecessor.
Case study 1: Sovereign engagement in Brazil
Following previous accusations regarding the use of illegal devices to cheat emissions tests carried out on diesel vehicles, the company has been an improving ESG story with many managerial and structural changes and increased focus on electric vehicles. Yet we view that the improvements on the ‘G’ side have been lagging, as its ownership is limited to outside investors, creating an opaque structure. Moreover, allegations of forced labour of Uyghur minorities led MSCI to assign a red flag controversy, and United Nations Global Compact status of Fail. Conversations with the company left the impression that there will be no quick solution or remedial measures that could be taken to change the downgrades. We have also asked for further clarification from MSCI given that other companies facing similar allegations have not been downgraded. We have taken our Fundamental ESG (Risk) Rating assessment from High to Very High and will be reducing our exposure in all our funds that are classified as Article 8 under the Sustainable Finance Disclosure Regulation (SFDR).
Case study 2: An automotive company
Equity buyers have traditionally been the ones engaging with companies. As shareholders – and therefore part owners of the business in question – they enjoy proxy voting rights, which give them the opportunity to influence corporate governance and directly engage with management teams on how the company is run. Bondholders are lenders, not owners, and do not have a direct legal mechanism of influence. But the importance of ESG in the investment community has changed this dynamic, unlocking the bondholder’s voice.
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Whether it is drought, sewage on beaches or impacts on energy supply, the challenges we face around water are very real, for people around the world and for businesses. There are many considerations for those of us seeking to invest in these challenges, which is why RBC BlueBay has released a detailed whitepaper on the subject, titled “The water challenge: a primer for investors”. In this article I’ve highlighted three key areas for investors to pay attention to.
As RBC BlueBay launches a new whitepaper on investing in water, Robert Lambert summarises three areas to be considering
MAY 2023
“Models which subsidise water services through public utilities or government agencies are probably unsustainable in the long term”
For governments to create a healthy ecosystem for water management, one of the most important considerations is the implementation of water tariffs. These pricing mechanisms charge users based on the amount of water they consume. A study of Organisation for Economic Co-operation and Development (OECD) countries in 2020 found that putting the right price on water encourages people to waste less, pollute less and invest more in water infrastructure. Yet the OECD study also found that tariffs for water and wastewater services remain low and inconsistent. This fuels water inequality and exacerbates water’s limited availability. Models which subsidise water services through public utilities or government agencies are probably unsustainable in the long term. An effective tariff structure will not only cover the cost of water provision and sanitation services, but also investments in infrastructure and capacity.
1. Countries operating water tariffs
One of the most effective ways to access innovation in water management is through established utilities companies. They have a vital role to play because they can provide the sustained investment that is needed to bring these innovations into widespread use. The BlueBay fixed income investment team has engaged extensively with water companies in recent years, and it is clear to us which are adopting progressive practices, and which are further behind in the journey. The following are some of the markers that we’re looking for. Firstly, there are a range of approaches to water treatment that water utilities ought to be adopting. Membrane filtration, advanced oxidation and UV disinfection are all means of removing contaminants. There’s also biosolids management, which isolates and treats nutrient-rich by-products of wastewater processes for use as a fertilizer. Secondly, there have also been significant advances in smart water systems. These use digital technologies such as sensors, data analytics and control systems to improve the efficiency and sustainability of water and wastewater systems. Finally, the value of integrated water resource management (IWRM) is increasingly being recognised by water companies. This discipline aims to consider the interlinkages between water, society and the environment, and typically involves a combination of demand management, supply management and water-quality management strategies.
2. Companies investing in innovation
“There are several interesting funding models emerging”
We believe established issuers tend to be the most reliable means for investing in water, but there are nonetheless several interesting funding models emerging. Notably, blue bonds are a type of debt instrument issued by governments, international organisations and private entities to finance projects promoting sustainable, water-related activities. A number are focused on oceans, while some are also being extended to provide social and economic benefits to coastal communities. They’re still a nascent market – most of the European utilities are issuing more traditional green bonds – but they’re one to watch. Then there’s ocean-based carbon credits, which are created by sequestering carbon in the ocean. Organisations engaging in marine conservation might achieve this by restoring mangroves, seagrass beds or other blue carbon ecosystems. They can then sell the credits on carbon markets to companies wishing to offset their emissions. Finally, there are a growing number of impact investment funds that focus purely on investing in sustainable ocean-related projects such as sustainable fisheries, marine conservation, and ocean energy. The key characteristic of these investments is that they are made with the specific intention to generate positive, measurable social-and-environmental impact, alongside a financial return.
3. Innovative funding models
Capital at risk. The value and income of investments and can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
This document is a marketing communication and it may be produced and issued by the following entities: in the European Economic Area (EEA), by BlueBay Funds Management Company S.A. (BBFM S.A.), which is regulated by the Commission de Surveillance du Secteur Financier (CSSF). In Germany, Italy, Spain and Netherlands the BBFM S.A is operating under a branch passport pursuant to the Undertakings for Collective Investment in Transferable Securities Directive (2009/65/EC) and the Alternative Investment Fund Managers Directive (2011/61/EU). In the United Kingdom (UK) by RBC Global Asset Management (UK) Limited (RBC GAM UK), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and a member of the National Futures Association (NFA) as authorised by the US Commodity Futures Trading Commission (CFTC). 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The registrations and memberships noted should not be interpreted as an endorsement or approval of RBC BlueBay by the respective licensing or registering authorities. Not all products, services or investments described herein are available in all jurisdictions and some are available on a limited basis only, due to local regulatory and legal requirements. This document is intended only for “Professional Clients” and “Eligible Counterparties” (as defined by the Markets in Financial Instruments Directive (“MiFID”) or the FCA); or in Switzerland for “Qualified Investors”, as defined in Article 10 of the Swiss Collective Investment Schemes Act and its implementing ordinance, or in the US by “Accredited Investors” (as defined in the Securities Act of 1933) or “Qualified Purchasers” (as defined in the Investment Company Act of 1940) as applicable and should not be relied upon by any other category of customer. Unless otherwise stated, all data has been sourced by RBC BlueBay. To the best of RBC BlueBay’s knowledge and belief this document is true and accurate at the date hereof. RBC BlueBay makes no express or implied warranties or representations with respect to the information contained in this document and hereby expressly disclaim all warranties of accuracy, completeness or fitness for a particular purpose. Opinions and estimates constitute our judgment and are subject to change without notice. RBC BlueBay does not provide investment or other advice and nothing in this document constitutes any advice, nor should be interpreted as such. This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product in any jurisdiction and is for information purposes only. No part of this document may be reproduced, redistributed or passed on, directly or indirectly, to any other person or published, in whole or in part, for any purpose in any manner without the prior written permission of RBC BlueBay. Copyright 2023 © RBC BlueBay. RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management (U.S.) Inc. (RBC GAMUS), RBC Global Asset Management Inc., RBC Global Asset Management (UK) Limited and RBC Global Asset Management (Asia) Limited, which are separate, but affiliated corporate entities. ® / Registered trademark(s) of Royal Bank of Canada and BlueBay Asset Management (Services) Ltd. Used under licence. BlueBay Funds Management Company S.A., registered office 4, Boulevard Royal L-2449 Luxembourg, company registered in Luxembourg number B88445. RBC Global Asset Management (UK) Limited, registered office 77 Grosvenor Street, London W1K 3JR, registered in England and Wales number 03647343. All rights reserved.
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With impact investing in fixed income markets, there is always an intentionality goal – investing in issuers that measure their contribution towards addressing the world’s environmental and social challenges. But for many impact investors, there is a need to also evidence ‘additionality’. This is the ability to prove that the positive outcome would not have occurred without the investor’s specific investment. However, it comes with its challenges. Firstly, additionality is much more easily demonstrated in private markets than public markets. Transactions in public markets generally occur between investors rather than for an issuer’s new financing needs. Secondly, additionality is more likely to occur in circumstances where investment attractiveness is low. It is commonly linked with philanthropic endeavours and, while these are important activities, they are not the only ones that should be considered to have a positive impact. We strongly believe there is a need to further explore how additionality should be defined and evidenced in the context of public markets. Particularly because of the public market funding gap and the need to scale up and accelerate action.
My-Linh Ngo, BlueBay Head of ESG Investment and Portfolio Manager
My-Linh Ngo discusses ‘additionality’ and the importance of providing a positive impact in building a sustainable future through public debt markets
May 2023
“It can be enormously valuable when activities are focused on transformational rather than incremental matters”
We also believe that there is the need for a more holistic approach to investing in public markets that gives a greater role to fixed income. Certainly, the risk/return profiles of some of the companies that require funding are more attractive to debt investors than to equity investors. And the large size of the debt market (compared to equities, for example) is evidence of the positive impact the asset class can have if directed appropriately Fixed income also affords the opportunity to directly fund non-corporate entities such as sovereigns, supranationals and agencies (SSAs), which play a critical role in determining policy and regulation of systemic risks such as climate change. Given that many environmental assets are ‘public goods’, there are limits to what the private sector can do alone.
A greater role for debt markets
It can be enormously valuable when activities are focused on transformational rather than incremental matters. The year 2023 has the potential to see a more meaningful, and much needed, allocation of assets towards this area. However, data and analytics are essential to help companies and investors show credible evidence of their contribution to real-world outcomes. We believe attention will remain on contributing positively to outcomes in the ‘real economy’. Debt markets will have their role to play in that, as will a nuanced view of additionality.
Valuable outcome for all
“The risk/return profiles of some of the companies that require funding are more attractive to debt investors than to equity investors”
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This document is a marketing communication and is issued in the United Kingdom (UK) by BlueBay Asset Management LLP (BBAM LLP), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and is a member of the National Futures Association (NFA) as authorised by the US Commodity Futures Trading Commission (CFTC). This document is intended only for “professional clients” and “eligible counterparties” (as defined by the Markets in Financial Instruments Directive (“MiFID”) ). No part of this document may be reproduced, redistributed or passed on, directly or indirectly, to any other person or published, in whole or in part, for any purpose in any manner without the prior written permission of BlueBay. Copyright 2023 © BlueBay, is a wholly-owned subsidiary of RBC. ® Registered trademark of RBC. RBC GAM is a trademark of RBC. Details of members of the BlueBay Group and further important terms which this message is subject to can be obtained at www.bluebay.com. All rights reserved.
Until recently, the limited range of opportunities for impactful investing in public debt markets stood in stark contrast to the scale and urgency of capital needed to fund the transition to a more sustainable world, as well as the level of investor demand to allocate towards positive environmental and social activities. Now, however, we genuinely seek to help our investors support the transition by investing in public debt markets. We are proactive about contributing towards addressing sustainability challenges that are aligned with our ESG themes.
Stewardship is becoming more recognised in public debt markets, though we have to consider how we do it, says My-Linh Ngo
“Engagement activities, as opposed to exclusionary or divestment approaches, may intensify in this sector”
An impact strategy in public debt markets predominantly focuses on selecting issuers and bond issuances which support economic activities contributing to positive outcomes and impacts in the real economy. We recognise, however, that there is also a role for responsible stewardship practices. We believe that there is a clear need to facilitate policy frameworks that enable the outcomes and impacts we are seeking to target. This means expanding and complementing the scope of our engagement beyond companies in the private sector to other key stakeholders such as governments, policymakers and regulators. The systemic nature of many of the environmental and social challenges which exist means we need to collaborate and partner with other stakeholders to increase our influence and deliver on progress.
The scope of our engagement
We must consider the scale and pace of change possible over time, given how multidimensional and complex the issues and interactions are. We also have to be pragmatic about the reporting challenges that can arise when supporting and fostering new types of economic activities. Investing in smaller companies that are under-resourced but which offer products and services that contribute positively may have less well-established ESG practices. This means managing expectations appropriately. Consequently, with impact investing we like to focus on ensuring a minimum level of acceptable ESG practices rather than necessarily requiring advanced ones. Our stewardship efforts also encompass working with other businesses across the investment industry to promote good or best practice on ESG and sustainability matters.
A pragmatic approach to ESG
“There is a clear need to facilitate policy frameworks that enable the outcomes and impacts we are seeking to target”
ESG regulations, as well as wider efforts to address ESG and sustainability impacts, will continue to drive the demand for data and analytics to help stakeholders, including investors, better understand risk exposure and performance outcomes. We see a growing movement of investors in ESG-linked fixed income products who are increasing their interrogation of issuers’ ESG efforts. We also think that engagement activities, as opposed to exclusionary or divestment approaches, may intensify in this sector as the benefits of engagement to create better outcomes become widely understood. This is a positive step for the ESG and responsible investment industry.
An increased focus on stewardship activities
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A relatively new development over the past few years has been the emergence of the ESG-labelled issuance market. This enables investors to signal their support for specific ESG or responsible investment (RI) priorities through funds or strategies that are seeking to achieve specific objectives. The use-of-proceeds market was the first element to develop, whereby funding is earmarked for spending on eligible products. These issuances can range from green-focused (e.g. clean energy or water management) to social (such as education or health projects). Or they might fund a combination of products based on the United Nation’s Sustainable Development Goals (SDGs). A more recent development has been the sustainability-linked issuance market, where instead of funding projects, the focus is on specific ESG targets, with payment of coupons typically linked to the achievement of these targets. Such developments are very welcome and can play a critical role in linking investors interested in investing with a purpose to issuers that align to that purpose.
The emergence of the ESG-labelled issuance market has been very positive but its growth could benefit from industry best practices, says My-Linh Ngo
“There is a clear need for better quality data and more analytics to help companies and investors assess the quality of ESG practices”
While European regulatory developments around ESG continue to dominate much of the headlines, this year we expect a broadening of geographical focus. The US and UK, among others, are expected to define the ‘what’ and ‘how’ of ESG/RI investments in their regulatory frameworks. The hope from companies and financial institutions is that there will be a harmonisation and standardisation of approaches across the different jurisdictions. But, while we may see this happen to some extent, the reality is that the regulatory landscape will likely continue to be fragmented, bringing challenges for global firms.
Regulation is getting even more complex
“The growth of the market could be damaged if its integrity is undermined by poor industry standards”
Getting the balance right in terms of being principles-based or prescriptive is proving difficult, and risks being divisive at a time when the industry should be coming together. The compliance and regulatory burden may also create challenges for those smaller players who can often be the source of innovative investment solutions in the sector. But there is a clear need for better quality data and more analytics to help companies and investors assess the quality of ESG practices. Despite some scepticism over ratings services and scores, issuer ESG scores are gaining greater popularity as the basis to determine the investable universe, and this is shaking up the ESG vendor landscape. In turn, we should get greater clarity of the ESG-labelled issuance market, which is expected to return to growth in 2023 and potentially reach $1tn in total.
The need for better data is clear
However, the growth of the market could be damaged if its integrity is undermined by poor industry standards. Given the potential opportunity and risks, we’ve been engaging with a range of stakeholders at different levels to encourage industry best practice and to foster trust and confidence in the market. Such efforts also help to ensure we have access to information from issuers, allowing us to better evaluate the quality of their issuances. One recent example of early engagement was our involvement in the development of the Emerging Markets Investors Alliance’s principles of ESG-labelled issuances. We have also worked with the Inter-American Development Bank to ensure its Green Bond Transparency Platform serves as a useful resource for investors.
Early engagement matters
By almost any measure, the US debt ceiling has been a costly failure. Uncertainty around raising the debt ceiling has led to repeated bouts of market volatility, higher government borrowing costs, and potentially years of slower growth, according to academic studies and US Government Accountability Office reports. The record-setting US national debt now exceeds the annual GDP, will soon exceed the record post World War II levels of debt-to-GDP, and is on pace to reach 135% of GDP by 2040, according to the non-partisan Congressional Budget Office. We believe that further down the track, the debt ceiling limit in the US is set to be a bigger issue than the market is currently priced for. There is a lot of complacency, but this can and probably will change quickly at some point during the summer. The so called ‘X-date’, which is the point at which the US Treasury runs out of cash, is a moving target that is dependent on the combination of tax receipts, spending and the effective management of cash resources. It is likely to be sometime towards the end of July but may even extend longer into August.
Russel Matthews, Senior BlueBay Portfolio Manager, RBC BlueBay Asset Management
Russel Matthews discusses a key macro theme that the markets seem less concerned with than maybe they should be…
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“We think that we are going to be faced with further volatility, in rates and in equities and FX this year”
While it is too early to be positioning for the event, it is swinging into focus. The most likely outcome is going to be a period of ‘risk-off’, driven by fears of either a default-type event or a swift and severe reduction in government spending that causes the market to anticipate a more severe economic downturn This will be a primary focus for us in the coming months and we anticipate a good opportunity to generate returns from this thematic. If you look at the SVB crisis, it is interesting to note that Jerome Powell, Chair of the Federal Reserve, was talking up the growth and inflation trajectory at the beginning of March and wanted to force a hawkish step change in the pricing of the Fed’s rate hiking path. It is very apparent that he was very unsuspecting of the chaos that would erupt in the US regional banking sector.
The debt ceiling heightens risks
“The protagonists in this drama are miles apart and the views are more entrenched and polarised than ever before”
We take this as a warning sign that stress can come out of nowhere, associated with sectors of the economy and or financial system that no one suspects. This will continue to be the case through the course of 2023, and we think that the market is somewhat complacent in this regard. Consequently, we think that we are going to be faced with further volatility, in rates and in equities and FX this year. But for us, that opens up opportunities in the macro sense.
Complacency creates opportunity
Polarisation continues to grow
When we analyse the politics in the US, we see more polarisation and discord than ever before. Kevin McCarthy, the leader of the Republican caucus in the House, has a razor thin majority and there is a group of hard-line Republicans who will not be shy to cause substantial volatility to get their way. The relationship between McCarthy, the Democrat controlled Senate and the White House is non-existent. The different protagonists in this drama are miles apart and the views are more entrenched and polarised than ever before. We think it unlikely a deal will be reached ahead of the X-date. The more difficult question is how to play this.
Capital at risk. The value and income of investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
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The past three years have thrown a curveball at emerging markets with Covid, the war in Ukraine, inflation, and social unrest from rising food and energy prices. Now, fiscal discipline comes under scrutiny as emerging economies operate with leaner budgets. “For emerging markets, it is about whether they can manage to navigate a relatively low growth global environment, while maintaining fiscal discipline,” says Polina Kurdyavko, Head of BlueBay Emerging Markets, at RBC BlueBay Asset Management. “On one hand, as a politician, you want to offer people on the street what they want by way of change; but on the other hand, you also understand that you are constrained by what you can offer with debt, liquidity, high rates and tight fiscal constraints,” she says. Emerging market governments must remain flexible enough to prioritise affordable access to food and energy, while pursuing development needs and debt management. “Last year, we saw a number of left-leaning leaders elected as part of the presidential elections in Latin America. It is a protest vote to some degree where people want change on the streets,” says Kurdyavko.
Opportunities in emerging markets as economies navigate a new set of challenges
While developed markets contend with central bank responses to high inflation, emerging economies face different challenges as they navigate rising costs and tighter budgets, yet opportunities remain in the asset class
June 2023
“Based on IMF predictions, Columbia is expected to reduce its fiscal deficit from -6.4% to -2.9%”
The global landscape has put pressure on emerging countries’ fiscal budgets. In low-income countries, higher spending partly reflects the government’s responses to spiking food and energy costs. “We are looking to see if they can stick to their budgets. This year, most fiscal projections in Latin America for example, with the notable exception of Brazil, are expected to be similar, or tighter, than last year,” Kurdyavko explains. “Based on IMF predictions, Columbia is expected to reduce its fiscal deficit from -6.4% to -2.9%. That is the biggest fiscal reduction we have seen. If Columbia can deliver on this and combined with double-digit yields on the local debt and the widest levels in the last 20 years on the sovereign hard currency debt, we think that is a great opportunity,” she says. However, Kurdyavko adds that Columbia’s performance could go in either direction if the government must spend more to keep the population happy – or if added pressure from volatile global inflation drives up borrowing costs as investors demand a higher premium for government debt. “Brazil is a special case in Latin America because you have projected fiscal widening going from -5.8% to -7.5% this year, so that is quite wide. The jury is still out on whether the market will support that,” she says.
Tighter conditions put spotlight on fiscal discipline
Apart from Chinese real estate, emerging market corporates have been very resilient over the last few years with an overall default rate of 1% in the corporate sector. Kurdyavko expects some volatility as corporates navigate profitability and cash flow generation this year. She says in a low growth environment with tight liquidity, we could see surprises on margins if companies cannot pass their costs on to the consumer. “On the other hand, if companies are too profitable, then the risk is that the government might look to take some of the profits from companies to support their fiscal efforts,” she says.
Corporate outlook
Overall, the tailwinds that underpinned the emerging markets rally at the start of the year should continue to be supportive, says Kurdyavko. First, central banks in emerging economies started their interest rate hiking cycle on average about 18 months ahead of central banks in developed economies. “This gave confidence to domestic investors, it helped support currencies, and it helped to rein in and manage inflation,” explains Kurdyavko. Second, balance of payments dynamics have been supported by commodity prices. “Regions like the Middle East benefitted the most, but even countries in Latin America are seeing a positive trend in current accounts. That removed a big vulnerability from emerging markets in general,” she says.
Support to continue
“Overall, the tailwinds that underpinned the emerging markets rally at the start of the year should continue to be supportive”
With so much geopolitical and macroeconomic uncertainty this year, investors could be forgiven for wanting to take a breather from markets. Yet, even as developed economies continue to grapple with inflation and experience turmoil from bank weakness, emerging economies are poised to remain resilient amid the turbulence. In emerging markets broadly, central banks have already done their part of the heavy lifting. They started interest rate hiking cycles, on average about 18 months, before developed economies started to raise rates. This precautionary action helped to control inflation, gave confidence to domestic investors, and helped to support currencies across emerging economies. “Most of the central banks have been pre-emptive, which has paid off. We have seen inflation in most emerging market countries already peaking and, in some places, we are seeing inflation surprising on the downside as it starts a downward trajectory,” says Polina Kurdyavko, Head of BlueBay Emerging Markets, at RBC BlueBay Asset Management. Meanwhile, robust commodity prices have improved balance of payments for several emerging economies, removing some of the vulnerability associated with the asset class. “If you put those two tailwinds together and then marry them with close to double-digit yields on emerging market hard currency debt, suddenly you are seeing very interesting investment propositions,” Kurdyavko says. “If I look at the sovereign index today, we started 2023 with yields close to 9%; and while yields peaked at 10% in October last year, a 9% yield for hard currency sovereign debt is quite appealing,” she explains.
Combining the advances of emerging economies with close to double-digit yields, is creating diverse emerging opportunities for investors for the year ahead, with BlueBay’s EM Unconstrained Bond and EM Select Bond strategies poised to benefit
“After years as an overlooked and unloved asset class, local emerging market currencies may be due for a comeback”
After years as an overlooked and unloved asset class, local emerging market currencies may be due for a comeback. “After a 10-year pause, this is precisely the time when it is worth looking at this asset class again. We see not only alpha opportunities but there is a beta argument for it as well,” she says. “This tide started turning last year because local currency was the best performing emerging market asset class in 2022 and particularly EM FX on a relative basis. For once, we have double-digit rates in emerging sovereigns and supportive valuation because FX has devalued by 50% to 60% over the last decade,” she explains. Kurdyavko says: “It’s not only hard currency that will be most exciting in the space, but it is also going to be best ideas across hard and local currency; and we think this opportunity will continue.”
Is local currency due for a revival?
Opportunity remains across the emerging market asset class, despite geopolitical uncertainty stemming from the war in Ukraine and a re-emergence of US-China tensions, the looming threat of a global recession and conditions of tight liquidity show no signs of abating. “The more uncertainty you have in the world, the more optionality you want. The EM Unconstrained strategy gives you the maximum amount of optionality because you look at the 40 best ideas in emerging markets across corporates, sovereign, local currency, hard currency. Investors are not constrained by the benchmark, by universe segment, or by duration,” explains Kurdyavko. The beauty of the product is that it looks at the best ideas across all segments but is also constructed in a way to reduce volatility by using different segments of emerging market fixed income to manage volatility down. “Every investor in emerging markets wants a portfolio constructed in a way to reduce volatility and they want to maximise the alpha opportunities in the asset class because we know it is an alpha-rich asset class,” she says. “If you look at the returns from our EM Unconstrained strategy over any time period, we have always run lower volatility than the index. We are in the top quartile, or decile, versus our peers because, on the return profile, we have had one year in the last 13 when we did not beat the index,” Kurdyavko explains. EM Unconstrained does not have a benchmark, rather it targets a LIBOR plus 4% to 6%. EM Select on the other hand, does have a benchmark, which is a 50:50 hard currency sovereign and local currency sovereign. “Both allow for the best ideas across local and hard currency sovereign debt that we feel are most interesting in this part of the cycle,” says Kurdyavko.
Why BlueBay EM Unconstrained and EM Select?
With so much geopolitical and macroeconomic uncertainty this year, investors could be forgiven for wanting to take a breather from markets. Yet, even as developed economies continue to grapple with inflation and experience turmoil from bank weakness, emerging economies are poised to remain resilient amid the turbulence. In emerging markets broadly, central banks have already done their part of the heavy lifting. They started interest rate hiking cycles, on average about 18 months, before developed economies started to raise rates. This precautionary action helped to control inflation, gave confidence to domestic investors, and helped to support currencies across emerging economies.
Investors have certainly been falling in love with the carry that emerging market fixed income investments have to offer. The yields of both the hard currency and the local currency fixed income indices are trading close to their 20-year highs, in many cases, reaching double-digit levels. The increase in risk appetite for emerging markets can also be seen in the reversal of flows since the beginning of the year with emerging market (EM) fixed income registering USD2 billion inflows year to date, albeit lagging inflows to the EM equity and US investment grade (IG) debt markets. The key question remains whether this trend is a tactical phenomenon or a structural shift.
Have you ever fallen in love? The feeling of happiness and euphoria provides plenty of scope for optimism and long-term planning. Yet the challenge lies in making the transition from this highly emotional state to one of long-lasting love. Patience, compromise, communication and commitment are key.
“The challenge now is transition from a stance of tight monetary policy and a relatively loose fiscal policy to counter the effects of the Covid pandemic and the Russia-Ukraine conflict to more dovish monetary policy and more conservative budgets”
“Investors have certainly been falling in love with the carry that emerging market fixed income investments have to offer”
There are certain elements that point in the direction of structural long-term changes. In addition to monetary policy orthodoxy and a supportive commodity price environment, we are also witnessing an interesting geopolitical reshaping of the world. The lukewarm relationship between the US and China is unlikely to improve in the short or even the medium term. However, given the interlinkages between the two countries, we are equally unlikely to see a sharp deterioration in the economic activity between the world’s two largest economies. What does this mean for the rest of emerging markets? In our view, the current geopolitical situation presents several advantages for large emerging market economies such as India, Indonesia, Brazil, Mexico and Chile to name a few. In the new geopolitical order, these allies become strategically more important. Given the ongoing Russia-Ukraine war and tensions between the US and China, the West needs as many allies among emerging market countries as possible. This is an opportunity for these emerging markets to change the rules of the game and dictate their terms when it comes to trade deals, portfolio flows and the level of tolerance vis-a-vis policy conduct in particular jurisdictions. Does a structural shift in positioning for these emerging market economies concerning their geopolitical stance also translate into portfolio flows? A few months ago, in a piece called ‘Frontier fortunes,’ I wrote about certain emerging market economies that are likely to struggle in the current environment. Is there a constructive trajectory for more established emerging economies? It is interesting to explore the consequence and the cost of policy credibility. Emerging markets have by and large been early to the hiking cycle. For example, in Latin America, most central banks now have double-digit policy rates, while inflation is already in a single-digit zone and on a declining trend. The immediate consequence of policy orthodoxy has been the stabilisation of domestic flows and currencies. We have already seen the market starting to respond to this through a higher focus on the local currency opportunities with EM local currency bond flows exceeding that of hard currency flows year to date. The JP Morgan Emerging Markets Global Bond Index has been a strong performer this year registering +7 total return year to date (8th May 2023).
While appealing to investors has its benefits, there is also a cost to restrictive monetary policy. For example, in Brazil, a policy rate of 13.75% is well above the nominal GDP growth rate of 8.5% as of December 2022. The Brazilian central bank Governor is adamant that the policy rate is appropriate, pointing to uncertainty on the outlook for inflation and fiscal discipline, as well as a relatively healthy state of the economy. However, with Brazil having the highest public debt to GDP ratio among large emerging market economies at 73% investors could start to worry about debt sustainability and growth implications. Indeed, every additional year of current policy rates in Brazil would add 1% to 2% to its debt-to-GDP ratio and have negative growth implications. In this environment, one has to navigate a fragile equilibrium between policy credibility and sustainability. In Colombia, meanwhile, policymakers are mastering a bipolar pattern where on the one hand the government is trying to maintain fiscal discipline and monetary orthodoxy, while on the other hand, the left-leaning president proceeds with a cabinet reshuffle, replacing a market-friendly Minister of Finance, among others, seeking popular support and votes, but creating more market volatility. While investors can often be attracted to double-digit yields, they should also be careful what they wish for. The double-digit cost of debt is generally not sustainable for countries or companies over the long term. If this trajectory continues, the only winners will be restructuring firms. I believe emerging market policymakers have gained a lot of credibility by being on the front foot of the hiking cycle. The challenge now is transition from a stance of tight monetary policy and a relatively loose fiscal policy to counter the effects of the Covid pandemic and the Russia-Ukraine conflict to more dovish monetary policy and more conservative budgets.
In this scenario, investors can register superior returns in EM fixed income assets compared to some of the developed market credits, where tight liquidity is likely to continue to weigh on companies’ margins and debt sustainability may be challenged in some private equity owned businesses. I believe most emerging economies are in a position to deliver this transition, from a tactical allocation (‘high coupon affair’) to a structural allocation in investors’ portfolios (‘true love’). However, as always, execution is key. The current environment can also create alternative sources of funding for emerging markets through private debt markets and blended finance. Given the need for capital for government-sponsored infrastructure projects, particularly in poorer emerging market countries, we could see market participants developing innovative solutions to bridge the gap that public market closure has created. This dynamic is not too dissimilar to the formation of European private debt markets over a decade ago. Even so, historically investors have been more comfortable with liquid emerging markets exposure given the volatile nature of the asset class. Extending the liquidity time horizon would require many investors to be convinced of the trustworthiness of their partner in this long-term relationship or to have that exposure de-risked with guarantees or other backing from multilateral development finance institutions or their developed market shareholders. This would also go some way to meeting the pledges made at recent international conferences for the rich north to transfer resources to the poorer south for so-called ‘loss and damage’ from climate change. For this, emerging market countries have to continue working on improving their institutions, in particular the judicial side including bankruptcy procedures, to become more aligned with some of the European economies, where progress has been made in recent years to improve creditors’ stance in debt restructurings. Over the coming months, ongoing sovereign restructuring discussions with countries such as Zambia and Ghana could provide investors with more clarity on how they can expect a new partnership to develop with these distressed borrowers. Should the stars align with successful outcomes, this could potentially pave the way for a new, more open and constructive relationship framework. We are currently at the crossroads where emerging markets have an opportunity to be added to the structural allocation of investors’ portfolios, thus migrating from a love affair seduced by a high coupon to advancing into a long-term partnership and true love.
Polina Kurdyavko, BlueBay head of emerging markets, RBC BlueBay Asset Management
There are certain elements that point in the direction of structural long-term changes. In addition to monetary policy orthodoxy and a supportive commodity price environment, we are also witnessing an interesting geopolitical reshaping of the world. The lukewarm relationship between the US and China is unlikely to improve in the short or even the medium term. However, given the interlinkages between the two countries, we are equally unlikely to see a sharp deterioration in the economic activity between the world’s two largest economies. What does this mean for the rest of emerging markets? In our view, the current geopolitical situation presents several advantages for large emerging market economies such as India, Indonesia, Brazil, Mexico and Chile to name a few.
It’s safe to say that financial markets are now experiencing a calmer environment after the turmoil in March. The banking crises at SVB, First Republic Bank and Credit Suisse brought back bad memories of 2008. The truth is that the issues we witnessed last month are very different in nature to those in 2008, though they are a clear reminder that aggressive policy tightening tends to cause something to break.
Marc Stacey, BlueBay Senior Portfolio Manager, RBC BlueBay Asset Management
Despite recent turmoil in the banking sector, markets should be encouraged by the strength of the sector's underlying fundamentals, says Marc Stacey
Learn more about the BlueBay Financial Capital Bond fund
“Capital levels remain close to all-time highs while the stock of non-performing loans is close to the lows”
“The collapse of SVB and First Republic has raised serious questions about the regulatory oversight of these smaller institutions”
The situation in Europe is markedly different. We are expecting to see further consolidation in the US regional banking sector, but this has already taken place over the last 10 years in Europe. It is also worth emphasising that European banks are regulated to a much higher standard and should not be vulnerable in the same way. Looking ahead, we continue to be encouraged by the banking sector’s underlying fundamental strength, particularly as European banks remain well provisioned and should continue to benefit from the rising rate environment. We believe that the price action within banks is contrary to the fundamentals.
European banks have greater regulation
US regional banks have a mismatch
In the US, it seems that a simplistic mismatch between the maturity of assets and liabilities is at the heart of the issues of some regional banks, with basic echoes of the savings and loan crisis of the late ‘80s. For these less-regulated, smaller US banks, it is clear that some of their business models were nowhere near as diversified or robust as their larger, more-regulated counterparts. The collapse of SVB and First Republic has raised serious questions about the regulatory oversight of these smaller institutions. There is no question that the regulation that was relaxed under the Trump presidency should be reinstated over time.
Capital at risk. The value and income of investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested
Banks have been at the epicentre of a crisis of confidence, but we do not believe that investors need to worry about a global financial crisis being triggered any time soon. We are encouraged by the response of regulators distancing themselves from the decision in Switzerland and to look beyond short-term volatility. Furthermore, banks have continued with their share buy-back programmes, which we think is extremely important to underline both the strength in the sector and the regulators’ confidence in their view of that strength.
The strength of the banking sector
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The fundamental resilience of banks is not being fully reflected in valuations, which continues to be a frustration, but one we are confident should correct over time. Even in light of a possible recession, the sector will be coming into the economic downturn from a position of strength and perhaps the best position it has ever been in at this point in the cycle. Capital levels remain close to all-time highs while the stock of non-performing loans is close to the lows. What is also different now compared to 2008 is that central banks are raising rates to fight inflation. This is helpful from a bank earnings perspective and should go some way in shielding any deterioration in asset quality. These factors are often overlooked in stressful times, but fundamentals always reassert themselves eventually. We believe European banks’ Additional Tier 1 debt (AT1) is likely to offer investors an upside, as the macro environment continues to prove challenging.
The resilience of banks ahead of any recession
The start of the year was extremely optimistic for Additional Tier 1 (AT1) debt. While pressures in the US regional banks and the shock of the Credit Suisse wipeout have had a very indiscriminate impact on the markets since then, we do not believe that this dynamic will persist. It remains attractive for banks to issue AT1 bonds as an alternative to equity despite the elevated spread levels. And while most banks have the capital flexibility to afford to be patient to an extent, we do not think this will keep them away from markets for a sustained period. On the other side, there remains significant investor demand for the asset class. European bank fundamentals are in robust shape, and this has been underpinned by record results in Q1. We would expect at current levels that new issuance would be very well received by the market, and this demand could be a catalyst for the market repricing to tighter levels and continue to recover some of the ground lost in the first quarter of the year.
James Macdonald, BlueBay Senior Portfolio Manager, RBC BlueBay Asset Management
The AT1 market has progressed since the turmoil in March, says James Macdonald
Read further insights from RBC BlueBay here:
“We continue to look towards high-quality banks with clear strategies and strong fundamentals”
“We believe that the risk-reward potential of the asset class remains incredibly attractive”
With close to EUR10 billion worth of AT1 bonds with call dates over the remainder of 2023 (since the Credit Suisse debacle), many investors are questioning whether issuing banks will choose not to exercise their calls. We believe most issuers will. This is the behaviour we have seen this year, with calls being exercised even at times of elevated spreads. Most bank management teams realise that investors want predictable behaviour, and they will be rewarded for this through tighter credit spreads across the cycle and through time. When management teams think about ‘call economics’, the vast majority realise that it is short-sighted to think about this on a bond-by-bond basis at a particular point in time. Further to this, we see the sector as carrying significant levels of excess capital, and this gives issuers the flexibility to call bonds and wait for more opportune market conditions to reissue, rather than to be hostage to particular periods of market volatility.
The ‘call economics’ of the AT1 market
The AT1 market recovery
In the short term, the secondary market seems to have absorbed the shock, even bidding up prices of AT1 subordinated debt. We have continued to see the market recovering since the shock of March and this has been against the headwinds of further issues with US regional banks, debate over the US debt ceiling and ongoing macroeconomic volatility. As these issues are worked through, we expect this will give the asset class the breathing space to recover further. While AT1 saw a setback in Q1, we believe that the risk-reward potential of the asset class remains incredibly attractive and an opportunity that investors will continue to take advantage of, over this year.
With all this in mind, our strategy is broadly unchanged. European bank fundamentals remain extremely robust. We always believe that over time fundamentals will reassert themselves and be efficiently priced by the market. We continue to look towards high-quality banks with clear strategies and strong fundamentals. We expect that with spread levels where they are, over the year the AT1 market presents an extremely attractive risk-return opportunity.
Fundamentals win over time
What are AT1 bonds?
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Impact investment is growing in popularity all the time. The Global Impact Investing Network estimates that the size of the worldwide impact investing market passed one trillion dollars in 2022, reaching USD 1.164trn.
Harrison Hill, BlueBay Portfolio Manager, RBC BlueBay Asset Management
From data challenges to attractive issuers, Harrison Hill runs down the how and the why of impact investing in public debt markets
Learn more about the RBC BlueBay Investment Grade specialism
September 2023
“The need for an ‘artistic’ approach is driven by the challenges around data”
There are also issues with the mainstream environmental, social and governance (ESG) data and ratings providers. Indeed, earlier this year, the UK Financial Conduct Authority (FCA) threatened them with regulatory action by over the potential for widespread failings due to ‘subjective’ methodologies. We believe these ESG ratings and metrics providers can have their uses, but there can be problems around methodological consistency and comparability of the outputs. Expanding utilisation of vendor data to impact reporting, when ESG reporting can at times be an imperfect science, has its perils and is an area where we are regularly engaging with our data providers.
Navigating ESG reporting
Harrison Hill,, BlueBay Portfolio Manager, RBC BlueBay Asset Management
What’s the secret to doing impact well?
Issuer selection is definitely an art rather than a science. The need for an ‘artistic’ approach is driven by the challenges around data. Companies may not report certain metrics, for example, their scope three emissions, and even when they do, they may calculate them in a different way than other companies. Investment grade issuers are better with disclosures than their counterparts in high yield or emerging markets, but there’s still a lot of incomparable or missing data. For us, it’s not just about screening out particular types of issuers – it’s about having a minimum level and then handpicking the most compelling, most impactful ones. In our impact-aligned strategy, we have a solid framework that determines an issuers’ eligibility for consideration. Still, after that, we spend a huge amount of time debating them before selection.
Despite these challenges, we are pleased with the progress we’ve made. There’s no doubt in our minds that the impact investment market will continue to grow and that public debt markets offer great potential for societal and financial returns in the years ahead.
Looking ahead
Within this ever-expanding market, fixed income is playing an increasingly important role. This is happening for two main reasons. Firstly, as the public debt market is bigger than the public equity market , there’s a huge amount of scope for investors to have an impact through this asset class. Investing via debt markets provides access to issuers and instruments that don’t exist in the equity world, enhancing the toolkit available to impact investors. Secondly, debt is an important part of the capital structure for issuing companies as the cost of debt is generally less than the cost of equity. It allows them to engineer their balance sheets to achieve tax efficiencies and reduces funding costs for the impactful projects they’re working on. That means there’s plenty of motivation for issuers to launch new bonds in the primary market. It also means that investors are valuable and can exert their influence through engagement or helping to structure new deals.
Fixed income’s growing role in impact
“We have hired a Scandinavian impact measurement firm to conduct in-depth assessments of the issuers we are looking at”
In the BlueBay fixed income team, for our impact-aligned reporting, we have gone off-piste and hired a Scandinavian impact measurement firm to conduct in-depth assessments of the issuers we are looking at via net impact ratios. They can also determine the impact of funds as a whole by weighting constituent net impact ratios to provide a top-level figure. We decided this was a necessary step to align our impact-aligned reporting with how we invest, netting pros and cons of the underlying business’ products and services on the planet and society while also providing a verification of sorts of our methodology.
1. Source: thegiin.org
2. Source: fca.org.uk
We have long been advocates of the fundamental strength of the European banking system and it remains the case, in our view, that the fundamental position of the sector is on extremely solid footing. Capital is robust, earnings continue to rise, liquidity is strong and non-performing loans remain at through-the-cycle lows. To an extent, we get the sense that the ongoing apathy in bank equities is in part driven by the fact that it’s hard to see further fundamental upside from here. We are, however, a bit more optimistic than the market in this regard and while we don’t expect the trajectory of ever higher capital levels and improvement to continue, the outlook remains very robust and completely at odds with both equity and credit valuations at this juncture.
As the dust settles on the collapse of Credit Suisse and several large US regional banks, James MacDonald argues that solid returns from AT1 bonds could be achievable
“While comments from regulators and Q1 results have gone some way to providing stability, spreads remain at very elevated levels”
“While consensus is beginning to point towards peak net interest income, we remain of the view there could be more to come”
The stresses that emerged from the US regional banking sector led many to question the fundamental improvements that we have long lauded in Europe since the global financial crisis. We would push back against this scepticism, and find it very surprising that European banks have repriced as much as US regionals, which we would view as the eye of the storm with more stresses likely to emerge. In our view, the market has not fully understood the detail between the different regulatory regimes that European banks, who follow Basel standards, and US regional banks adhere to, as well as the currently much more favourable operating environment for the European banking sector.
European banks vs US banks
Why the concerns?
Following the events of Q1, we see debt and equity markets climbing up a wall of worry when it comes to European banks. On the equity side, this is more earnings related, and the prevailing view is that even though the environment can’t get much better for banks, bank stocks still can’t seem to rally. However, while consensus is beginning to point towards peak net interest income (NII), we remain of the view there could be more to come. Deposit betas (the pace of passing through rate hikes to depositors) remain much lower than expectations and, on top of this, more rate hikes have continued to be priced in as we have moved through the year.
The events in the US and the downfall of Credit Suisse caused a significant repricing of the additional tier 1 (AT1) asset class as the market digested the events that had passed. While comments from regulators and Q1 results have gone someway to providing stability to the market, spreads remain at very elevated levels. Year-to-date tights in spread were 352, with wides of 659 reached in the week after the Credit Suisse rescue. Since then, we have retraced somewhat and are now at an index spread of 408. While this is a significant retracement, we are still at very elevated levels on a historic basis and, at the same time, the risk-free rate is at levels last seen pre-financial crisis. As a result, the all-in yield of the asset class remains at c.8.4% (as at 11 August) which looks extremely attractive, particularly for a sector that is naturally quite short duration and where the fundamentals benefit from higher rates. In the chart below, we have plotted the historic 12-month forward returns for a given level of spread since the inception of the CoCo index. Using a ‘best-fit’ line of historic returns, the level of spreads we are currently at predicts double-digit levels of returns for the next 12 months. Further, this predictive model does not take into account that yields are at these highs since the index inception, which will also play their part in the total return for the asset class over this period.
Valuations
When combined with the fundamental backdrop described above, we are very optimistic that these types of returns are realistically very achievable.
We continue to be encouraged by the strength of the banking sector’s underlying fundamentals, particularly as European banks remain well-provisioned and continue to benefit from the rising rate environment. During H1 2023, banks have been at the epicentre of a crisis of confidence, but we believe it has now been contained and the market is finally at a point where it can begin to look forward against a stronger technical backdrop. While the price action within banks seems contrary to these fundamentals, we are confident that this will correct over time. Even considering a possible recession, which is what is being priced despite central banks making ongoing upgrades to their near-term outlooks, the sector will be coming into any downturn from a position of strength.
12 month returns at a given spread
Source: RBC Bluebay Asset Management, Bloomberg, as at 31 May 2023.
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Abhi Jain, Head of Sales, UK, Ireland & Middle East, RBC BlueBay Asset Management
From the likelihood of meeting the 2% target to the risk of overtightening, Abhi Jain addresses the key points
“What we don’t see is a return to inflation rates around 0-2%”
The target was set at this level because, historically, that’s how we’ve seen economies behave in developed markets. Back then, countries’ balance sheets were cleaner and there was less pressure to print money. All of this is now being challenged. Going into this cycle, where interest rate rises are not combating inflation as quickly as we’d like, I think we will have to question whether the target is realistic. We need to look again at the theory and the numbers in this new regime.
Is the 2% inflation target realistic?
How do you see the trajectory going forward?
In developed markets, we do think inflation will trend lower, partly as last year’s energy price rises disappear from the data and partly as higher interest rates filter into the real economy. However, what we don’t see is a return to inflation rates around 0-2%. Levels of 2-4% are much more likely in this cycle. For emerging markets, it is difficult to generalise as it depends on each country or segment. However, EMs are entering this cycle in much better shape than they did the 2007–2008 financial crisis, with many having acted decisively to tackle their inflation pressures.
It’s generally accepted that the full effect of any interest rate rises takes between six and 12 months to filter through. This makes it harder for central banks to be precise about the extent of their intervention. However, we don’t see an overcorrection as our base scenario because of the factors pushing us towards a soft landing. In the run up to the global financial crisis, both consumers and corporate were much more highly leveraged. There was a free money attitude, which is not the case this time.
Is there a risk of central banks overtightening?
When it comes to explaining how inflation beds in, I like to think about yogurt prices. There’s a luxury yogurt that I absolutely love – it was 55p, then it went to 85p, and now it’s £1.05. On one level, I’m thinking: “It’s the same content, if anything they’ve reduced the volume of the goods inside and just jacked up the price.” But, does that stop me from thinking “ah, this is a treat”? I might reduce the number I buy in a week, but I still gravitate towards it. That’s what happens in an economy where there is still strong demand for goods, as we are currently seeing. Logic would suggest that I should save up for when my mortgage renews in November, but in practice I’m not giving up my consumption habit just yet. Of course, demand isn’t the only thing keeping inflation high at the moment. Tightness in the labour market is certainly a factor. That’s most evident from the UK perspective, but employment rates are also still sticky in the US. We haven’t seen a collapse in jobs, and if anything, we’re seeing wage inflation filtering into the economy. There are other factors too. We are trying to rely less on carbon by seeking out greener sources of energy, and that doesn’t come cheap. There has also been a move away from globalisation, with countries trying to bring supply chains home. That’s feeding into the labour market tightness mentioned earlier.
What is keeping inflation sticky?
“The full effect of any interest rate rises takes between six and 12 months to filter through”
When we talk to clients, we prefer to talk about a diversified portfolio rather than short-term fixes. Hopefully most clients’ portfolios are already hedged through allocations to real estate or inflation-linked bonds. That said, a couple of years ago, inflation-linked bonds weren’t offering attractive value so weren’t high up the agenda. Nowadays, higher real yields and sticky inflation are making them more attractive, so we are seeing an uptick in clients adding inflation-linked debt as part of their overall mix.
How do I protect my portfolio from continuing inflation?
Read further insights from RBC BlueBay
Nesche Yazgan, Senior Corporate Analyst, Investment Grade, RBC BlueBay Asset Management
Capital goods and packaging are just two areas that look attractive despite where we may be in the credit cycle, says Nesche Yazgan
“One sector we like at the moment is capital goods, specifically in areas with pricing power”
Reasons to be cheerful
In this context, investors might be forgiven for running for the hills when it comes to issuers in cyclical sectors. However, there are two reasons why this would be misjudged. First, hopes of a soft landing are rising. Despite almost 500 basis points of interest rate hikes in the US, we have yet to see any serious deterioration in company fundamentals. And second, even if a downturn does come, cyclical issuers can still be viable, but the important thing is to protect yourself by being selective. This means seeking out those issuers with resilient balance sheets, good market positioning and geographic diversification.
So overall, we have remained relatively neutral on cyclicals, retaining exposure to those issuers with good fundamentals. We can’t be sure where the cyclical journey is heading, but we can look for companies that can be nimble about cutting capex to generate cash flow or have low leverage. As well as balance sheets, we look closely at companies’ product portfolios, the types of businesses they are running and, more importantly, how resilient the customers in their end markets are. Some very well-placed cyclical companies can come out of any potential downturn as winners with enhanced market positions while delivering good returns for their stakeholders.
Finding the right attributes
Fixed income investors are understandably wondering whether we are at or approaching the ‘downturn’ phase of the credit cycle. Central banks have been raising interest rates aggressively to control inflation, and in these circumstances, we would often expect recession to follow. Tighter credit conditions would come with that.
One sector we like at the moment is capital goods, specifically in areas with pricing power. Investment grade companies tend to have big balance sheets, and there are issuers with great market positions in automation, robotisation, oil and gas production and aerospace supply chains. We’re particularly interested in those that have exposure to the US. We see better fundamentals here than in Europe and certainly in China, where the recovery has been extremely sluggish. Elsewhere, we like packaging companies that have robust fundamentals. This sector has good pricing power because the market is very concentrated and, therefore, not very competitive. Companies have been able to pass on significant cost increases as a result and now have the potential to benefit from cost decreases in their input material over the past two quarters. Finally, we like aerospace companies and suppliers as we think they have solid long-term fundamentals, and we like airline companies because traffic numbers have returned following Covid. The latter are classic cyclical issuers because consumers tend to cut back on overseas travel if they are feeling the pinch. Yet they are looking robust at the moment, with holidaymakers spending their savings.
Sectors to consider
On the flip side, we are staying away from areas where consumers depend on financing to purchase big-ticket items. Cars, for example, look vulnerable, even though we’ve been surprised at the sector’s resilience so far. Supply chain issues allowed auto companies to aggressively price following the pandemic. Still, demand could now turn, given the increase in interest and leasing rates as well as potential pressure on employment levels. We’re also cautious about construction. Interest rate increases have made this sector very exposed especially with regard to new activity in commercial property and residential, and we feel our caution has been vindicated by recent performance.
Areas to avoid
One sector we like at the moment is capital goods, specifically in areas with pricing power. Investment grade companies tend to have big balance sheets, and there are issuers with great market positions in automation, robotisation, oil and gas production and aerospace supply chains. We’re particularly interested in those that have exposure to the US. We see better fundamentals here than in Europe and certainly in China, where the recovery has been extremely sluggish.
Tom Moulds, BlueBay Senior Portfolio Manager, Investment Grade, RBC BlueBay Asset Management
Set to outperform? Why European corporates look attractive vs the US
We are seeing value in European investment grade corporates relative to their US counterparts, says Tom Moulds
“European bonds underperformed materially in 2022 due to Europe’s proximity to Ukraine”
What pushed European spreads up?
To understand why European spreads may improve, we first need to understand what drove them up in the first place. There are three main reasons. The first and most powerful was the start of the Russia-Ukraine war. European bonds underperformed materially in 2022 due to Europe’s proximity to the region and the perceived impact on European companies. Sectors like industrials and utilities, were very exposed to volatile energy prices and were big drivers of underperformance. For example, German chemical companies use substantial amounts of energy. That created the initial widening between European and US spreads, but a second driver came into play just as the energy situation started improving. This was an escalation in financial bond supply. 2022 was one of the worst years on record for fixed income returns, and as a result, there had not been a lot of primary market activity, particularly from issuers such as financials. But as conditions started to improve towards the end of the year, European banks needed to fulfil their regulatory capital buffers. This meant issuing senior non-preferred debt, and the resulting influx of financial bonds caused the market to keep repricing. Moving into 2023, the third curveball was volatility in the banking sector. It began in March with the collapse of Silicon Valley Bank, which initially drew markets’ attention to US financial fixed income. However, later that same month, Credit Suisse had to be rescued from collapse by UBS, and the focus turned very much back to Europe. This ensured that European corporates continued to trade more cheaply than those in the US, and with financial supply still elevated, the trend continues today.
So why will European corporates rebound? Firstly, when it comes to banking, we believe the Credit Suisse situation is unlikely to be repeated in Europe. There are fewer banks in Europe than the US, and they tend to be bigger, well-capitalised national champions. This was put to the test in the aftermath of the Credit Suisse rescue when it was very apparent that Deutsche Bank and Société Générale were the most likely candidates to be tested by the market next. However, although the market tried to go after them, it quickly became clear that years of regulation had put them in a stronger place, and they were much more profitable institutions than Credit Suisse.
What this means going forward
From a valuation perspective, European corporates now look pretty attractive. The spread to government bonds is trading around 20 to 25 basis points wider than corporates in the US, and at times over the past year, the gap has been even bigger than that. This is all the more noteworthy because, historically, the relationship would usually be the other way around. You would typically expect European corporates to trade tighter than those in the US, not least because the average duration across the US corporate bond market is a full two years longer with a similar average credit rating. We believe that these elevated yields represent an opportunity, as there is a good chance that European corporates will outperform going forward.
“We believe the Credit Suisse situation is unlikely to be repeated in Europe”
Alongside all of this, it is worth being aware that cross-currency conditions also look favourable for euro-denominated debt. Asset managers use short-term FX to hedge out currency risk, and when you adjust the yield dynamic between euros and dollars using this method, euros look attractive.
PS…cross-currency is favourable too
As for energy, there are still some concerns, but we have come back a long way since the elevated prices we saw in 2022. Some potential for volatility remains, but the companies that might be exposed are in a much better position to deal with it now. They will have hedged their energy prices at lower levels to protect themselves over the winter, meaning credit spreads are unlikely to be affected by energy volatility to the same degree as previously. Finally, our view on the Russia-Ukraine war is that it is starting to head in a better direction and that by the end of the year, it is possible that the narrative may well be more about de-escalation. This would also lead to some relief in terms of energy prices.
Anthony Kettle BlueBay Senior Portfolio Manager, Emerging Markets
We believe that these countries could offer upside potential, says Anthony Kettle
October 2023
“Turkey benefits from very positive demographics and, as the bridge between Asia and Europe, a privileged geopolitical position in the world”
Argentina – change is in the air
Argentina has suffered over the past four years due to poor economic policymaking. Having defaulted on the country’s debts in 2020, Alberto Fernández’s government later resorted to money printing to fund a large national deficit, pushing inflation as high as 115.6% in June. It might seem strange, then, to consider Argentina as an investment opportunity. But there are a number of reasons for optimism. First, Argentina has been investing in a vast shale gas reserve called Vaca Muerta. In the past, the country’s strength as an agricultural exporter has always been offset by the fact it was a net importer of energy. That is about to change. A shift to an energy surplus could help to stem the drain of dollars from the country and allow the importation of necessary goods to grow the economy. Second, Argentina has national elections coming up in October. We anticipate that the government’s economic record will lead the public to vote for change, ushering in a more market-friendly government with more orthodox economic policies. Finally, Argentine bonds are trading at very distressed valuations. The market has not greatly recovered from the default in 2020, and prices are sitting anywhere between 25 and 35 cents on the dollar. This means investors are reasonably protected on the downside, with positive catalysts potentially in the offing.
The case for Turkey may not be quite as clearcut, but the country nevertheless deserves its position as “one to watch”. Like Argentina, Turkey has suffered from unorthodox economic management. Over the years, President Erdoğan has frequently been reluctant to raise interest rates because of the effect on growth, and in current conditions that has pushed inflation as high as 85% at times. He has also wanted to maintain a stable exchange rate, and the only way he has been able to do that is by spending the country’s FX reserves. Turkey differs from Argentina in that its general election has already taken place, and Erdoğan remains in post. However, there are signs that economic policy is becoming more orthodox anyway. Mehmet Şimşek has been appointed to the finance ministry and Hafize Gaye Erkan to the central bank with a mandate to raise interest rates.
Turkey – a positive direction of travel
Accordingly, since June interest rates have risen 21.5 percentage point to 30%. Turkey has also been looking to tighten up public spending and reduce the demand-side stimulus introduced prior to the election. This shift is interesting because Turkey benefits from very positive demographics and, as the bridge between Asia and Europe, a privileged geopolitical position in the world. However, there is still room for caution. Markets have already given Erdoğan some credit for the policy shift, so valuations don’t look quite so attractive as in Argentina. Turkey also still has a long way to go in taming inflation, and Erdoğan has been known to tire of orthodox policy, so the road ahead may be bumpy. Nevertheless, the direction of travel appears positive at present. Turkey may look expensive compared to other single B sovereigns, but if things continue to stabilise then we believe that we could see agencies upgrading their ratings or at least putting the country on a positive watch. We also believe that there may be near-term opportunities in inflation-linked bonds given that substantial price rises are likely to continue for the next few months.
The outlook for interest rates, defaults and growth are all looking positive, says Anthony Kettle
Some investors have been increasing exposure to emerging market corporates this year, and it could be because these regions appear to be ahead of the cycle. Emerging market governments can take some credit, having, in many cases, hiked interest rates early and aggressively. Past experiences of inflation in these parts of the world left most policymakers in little doubt about the need for decisive action. Brazil is a good example. It began raising rates from a low point of 2% in March 2021, reaching 13.75% by August 2022. Accordingly, inflation fell from 12.1% in May 2022 to just 3.2% in August this year.
“Xxxxxxxxxx xxxxxxxx xxxxxxxx xxxxxxx xxxxxxx xxxxx”
When it comes to economic growth, we’ve seen something approximate to the “soft landing” that has been much talked about in the developed world. We’re not seeing many countries with a negative growth outturn at all – collectively, we’re expecting EM growth of around 3.8% this year and 3.6% next year. For example, if we look at some of the countries in South America which have had weak growth outcomes this year, such as Chile, Peru, Argentina and Colombia, all except Argentina are expected to show sequential improvements as we move into 2024. Regarding those countries discussed earlier as having a more challenging default situation, our view on the progress of the Russo-Ukrainian War is cautiously constructive. We see the potential for some sort of off-ramp or frozen conflict, and any reconstruction phase is likely to benefit economic growth. On the downside, China is more of a concern. We’re seeing weakness in economic growth, and the stimulus coming through from government is fairly piecemeal. It doesn’t help that the country is continuing its substantial deleveraging programme, designed to control its debt-to-GDP ratio. Indeed, we’re almost seeing deflation in China, and when you put that alongside weaker-than-expected growth, investors might prefer to skew to corporates or sovereigns which are more leveraged to the US and global growth cycle than the Chinese one.
Achieving the mythical soft landing?
Although this was painful during the period of rate hikes, the subsequent plateauing at higher rates and yields has created a fertile environment for fixed income investors. Now, as we look forward, many emerging countries are actually starting to cut rates. For example, Brazil has been cutting in 50 basis point increments, while Chile recent cut by 100 basis points and then a further 75. This could provide a further tailwind as bond values rise and holders benefit from capital appreciation.
1. Source: uk.investing.com
2. Source: uk.investing.com
Source: uk.investing.com
Interest rates and inflation in Brazil
“The most levered and most at-risk companies have now fallen by the wayside”
To look at another important metric, we can speculate that corporate default rates may be similarly ahead of the curve, in the sense of being past their peak. Certainly, high yield EM defaults have been much higher than in the developed world over recent years, running at 7% in 2021, 14% in 2022 and 7% in the year to date. There are some mitigating reasons for this – a lot of it has been driven by Chinese real estate and geopolitical events in Russia and Ukraine rather than serious weakness in the fundamentals – but we can nevertheless anticipate that a good deal of the pain is out of the way. Certainly, the most levered and most at-risk companies have now fallen by the wayside. This is mirrored in corporate funding costs. Taking Brazil as an example again, AA corporates have seen their funding yields rise from 3% three years ago to around 15-16%. At the same time, consumers have also been stretched by higher interest rates, affecting demand for goods and services. Now though, if interest rates are starting to fall, then we can anticipate that funding costs may come down too. We can also take heart from the fact that the more prudent issuers took the opportunity to term out their maturity profiles during Covid. So, many of those with debt due in the next one, two or three years issued, where they could, longer maturity bonds at what were in hindsight relatively low levels of yield.
Default rates
Investors’ attentions tend to be on developed markets and emerging markets. But what should we consider when we think about frontier markets? These markets are, by definition, less developed than those in the other two groups, particularly on the corporate debt side. Yet there are opportunities to be harnessed, particularly among sovereigns, with the added bonus that they tend to be less correlated with other markets. This makes them a useful diversifier. So what, then, is the outlook for countries in this asset class? They can be broadly placed into two groups: performers and defaulters.
Debt in these countries can be a useful diversifier as long as you selectively assess the performers and the defaulters, says Anthony Kettle
“Those countries that have been prepared to work with the IMF have ultimately done a lot better than those who have tried to go it alone”
Angola is in a similar bracket. It is very leveraged to the oil price, which can be a concern, but it nevertheless has a lot of potential given its demographics and rich natural resources. The Angolan government has a stronger fiscal anchor than some of its neighbours, and it is also working closely with the International Monetary Fund (IMF). Kenya is also considered to be a “survivor” at this point in time, having made it through Covid and the aftermath without needing to default (it turned to the IMF for support). Both countries, therefore, are in reasonable economic shape and are providing healthy levels of yield. Finally, Gabon is noteworthy having been in the headlines recently. This summer it entered into a $500m debt-for-nature swap, the largest such deal ever issued by an African nation. This has allowed it to refinance some of its debts at lower interest rates while supporting marine conservation efforts in the country. However, a short time afterwards there was a military coup. Bonds which had rallied significantly, suddenly dropped 10 points overnight, illustrating the political instability that can be seen in frontier countries.
The performers
Among the “performers” are some of the bigger names in Sub-Saharan Africa, including the biggest of them all, Nigeria. Here, there are hopes for a positive economic trajectory. New president Bola Tinubu has acted quickly to introduce economic reforms, most notably removing trading restrictions on the naira currency and withdrawing subsidies for petrol. These were welcomed by investors as beneficial for the long-term health of the economy, though Tinubu faces implementation challenges as voters bear the nearer-term costs. Alongside this, we believe that investors in Nigeria can anticipate minimal near-term default risk and an attractive yield.
Economic disruption during Covid, followed by a period of rising interest rates, has put pressure on a number of sovereign issuers, often exacerbating pre-existing challenges. The default rate has therefore been relatively high over the past couple of years, as some countries face a choice between paying bondholders or buying food for the local populations. The three most notable defaulters have been Zambia, Sri Lanka and Ghana. They are all currently going through debt restructurings which have brought their share of pain. However, they’ve begun to trade a little better over the past few months and it looks as if we’re closer to the end of the process than the beginning for all of them.
Defaulters and one on the cusp
A country which has come close to defaulting but not quite done so is Pakistan. Last year’s floods were a major catastrophe as well as a significant drain on funding, and it looked like the country might run out of road this year as a maturity wall approached. However, it secured a deal with the IMF which has shored up the fundamental picture and allowed more funding to come in from other channels. The IMF is an important anchor in frontier markets. Those countries that have been prepared to work with the IMF have ultimately done a lot better than those who have tried to go it alone, so a restructuring programme is a big source of reassurance for investors.
Given the less developed nature of frontier markets, it is necessary to be selective. One consideration is hard versus local currency. In the dollar world, the instruments are standardised which means there is less distinction between trading liquidity for a frontier market and an emerging one. However, you have to be careful how much you hold in local currency bonds because, at times, it can be challenging to convert investments back into dollars and repatriate them. Liquidity can be especially short in the wake of a big macro event, which can tend to affect multiple frontier markets at the same time. It is also a reality that the corporate bond markets are less developed than the sovereign ones, meaning fewer issuers to choose from. Kenyan corporates, for example, have no bonds outstanding while Sri Lanka only had a small airline bond outstanding, although that was a quasi-sovereign. Nigeria, as the largest economy, has a more developed corporate sector with some issuance in financials and telecoms. There are also oil-and-gas companies, in Nigeria and elsewhere, which might even be listed overseas but which are nevertheless included within the index because they’re developing operations in those countries, such as some of the companies operating in Ghana. And Zambia has some mining opportunities, such as First Quantum. Export-related sectors can be particularly interesting for investors. An issuer might be a very good operator with access to good underlying assets, yet their valuations are penalised by the geography in which they operate.
Considerations when investing
“Corporate bond markets are less developed than the sovereign ones, meaning fewer issuers to choose from”
Emerging markets and long-short portfolios are worth considering right now, though don’t forget the UK completely, says Abhi Jain
“Not only do EMs increase geographic diversification within your portfolio, but they also reduce correlation risk”
Diversification options
We are seeing a lot more value in emerging markets, particularly if you are willing to be active –unconstrained EM strategies did phenomenally well coming into this cycle. Not only do EMs increase geographic diversification within your portfolio, but they also reduce correlation risk and offer a potential uptick in yield. That said, the ideal approach will depend on your particular needs and preferences. Some of our clients are currently looking to de-risk and are questioning whether EM is the right approach for them. We believe that sticking with emerging markets is a great option, given where yields are currently, but a global high yield mandate may cleave that little bit closer to the benchmark and help to weather the cycle. By contrast, other clients have a more growth-centric mindset. Here, we think it is time to move into long-short portfolios. These have been out of favour for a long time, but the current point in the cycle is an opportune time to actively short companies. At RBC BlueBay, we might take a short position because we think a company is not well placed to weather higher interest rates, or we might come from a sustainability angle – for example, if a company has governance challenges or social issues.
At the same time as all this, it is important to remember that the UK does actually have its appeals, given that the Bank of England’s rate hiking cycle looks to be coming towards its peak. The market is pricing in rates of 6.5% by the end of 2023, and we’re only 1.25 percentage points away from that. Meanwhile, gilt yields are continuing to rise in response to demand, supported by that home bias from UK investors. Of course, we recognise that the UK’s national finances are in poor shape and that the Bank of England has been impacted by losses on past asset purchases. There are also technical headwinds – at a time when the UK government needs to issue debt, the dynamics of the LDI market mean that there are fewer longer-dated gilts than are needed to hedge liabilities as gilts rise. However, while we’re keeping these factors in mind, we believe there are good opportunities to be exploited at the shorter end of the curve.
Appeal of the UK
Investor home bias has been called one of the six major puzzles in macroeconomics. The tendency for investors to prefer owning stocks and bonds in their own country has endured, despite technology and globalisation making cross-border transactions a lot easier. Yet, things are changing. There’s no doubt that UK portfolios have become more global over the past couple of decades, as investors become more confident with global markets. This global outlook may still be fairly US-centric and have a developed market flavour, but investors are increasingly taking a risk-adjusted view of emerging markets too. So, for those who are considering their global allocations, what’s the best way to ensure a properly diversified portfolio?
“It is always worth reflecting on the appropriate mix to ensure the best diversification possible”
The bumpy reopening of supply chains following the pandemic has demonstrated just how globalised and interdependent the world’s economies are. Most of the client portfolios that we manage have a global tilt to them, but it is always worth reflecting on the appropriate mix to ensure the best diversification possible. The UK definitely still has a role to play in that mix, but we’re also finding opportunities in other parts of the world, whether in other developed markets or in emerging ones in Asia, Latin America and elsewhere. Ultimately, it's through looking further afield and off the beaten track that we believe we are able to harness the best risk-adjusted opportunities.
A world that’s more globalised than ever
1. Source: nber.org
Not only do EMs increase geographic diversification within your portfolio, but they also reduce correlation risk”
Rising issuer dispersion in investment grade corporate fixed income creates a fertile hunting ground for active managers, says Andrzej Skiba
“There had been a dramatic difference in the regional banks’ performance versus the global, systemically important ones”
Andrzej Skiba, Head of US Fixed Income
The turbulence in bond and credit markets has driven wider dispersion in investment grade credit, providing active managers with a compelling entry point to capture opportunity across sectors. Elevated dispersion is associated with a turning point in the economic cycle and particularly when macroeconomic conditions take a turn for the worse. Investors, rather than focusing on valuations and on the current state of market conditions, look to the risk of rating downgrades and a pickup in defaults to guide their views. This year’s recent market volatility has created divergent views among investors, particularly when they start to see signs of meaningful differentiation in the performance of individual sectors or rating groups. So, sometimes rising dispersion is symptom of what is already obvious within our investible universe and sometimes it's a harbinger of what could well happen, although there is no assurance.
Dispersion could pick up further down the line if the economy takes a turn for the worse. What we saw earlier this year with regional banks versus money center banks would be magnified to a greater number of sectors, a greater weight of our investment universe, and it would be more noticeable in dispersion statistics. Although there is no assurance that inflation will continue to moderate at the pace that is required by central banks in the quarters ahead and the US economy has been relatively resilient; deteriorating conditions could continue to favour active managers. We must be vigilant because there is a big difference in the performance of our asset class between the more benign and the more negative scenarios.
Dispersion to continue to climb?
“Dispersion is a source of alpha for an active manager looking to identify mispricing and opportunities in sector underperformance”
Climbing dispersion in fixed income poses problems for those investors looking to ‘buy the market.’ However, at the individual issuer level and often even at the individual security level, and when compared to the rest of the universe, dispersion is a source of alpha for an active manager looking to identify mispricing and opportunities in sector underperformance where it is not justified. For the bottom-up investor this is one of the core ways to outperform a benchmark over time. We generally find that pure bets on market directionality, when you put your crystal ball and decide whether spreads go wider or tighter, the information ratio of those kind of bets is lower than of issuer-specific, catalyst-driven opportunities where we find those have a much better rate of success over time. Yet many managers are not able to take advantage of dispersion successfully due to the inability to source the securities in a size that makes a difference. If you're running hundreds and hundreds of billions of assets within your investment portfolio, that ability to source issuers or sectors where you want to reflect on that dispersion or mispricing, it's much more difficult to effect and then you're more reliant on beta drivers of the market.
Not a time to stay passive
Within sectors, in the spring of this year, when markets saw the blow-up of regional banks in the US, there had been a dramatic difference in their performance versus the global systemically important banks (G-SIBs). That created an opportunity for investors because they came from a point where regional banks prior to the SVB crisis were trading at spreads tighter than those of the money center banks. In the aftermath of SVB and First Republic collapse, G-SIBs were trading around 200 basis point spread at the 10-year maturity point whereas regional banks were trading anywhere between 300 to 400 basis points. That dramatic increase in dispersion created an opportunity for investors to bet on normalisation of trends in that space. Another sector for opportunity is in the technology space. Here, the market has been assessing equity-related factors, yet showing disagreement about their validity from a credit investor’s perspective.
Some sectors offer select pickings
Earlier in the year, there was significant pressure on names in the semiconductor space. To shift away from Asia, companies had to spend significant capital on building up the production capacity in the US, which led to unwelcome dividend cuts for equity holders. But credit investors realised if the companies are cutting dividends to benefit credit holders and they want to defend their ratings and they're spending money on CapEx rather than share buybacks or dividends, well that's actually good from a credit perspective. Finally, commercial real estate is one growth-sensitive area that should not come as a surprise, particularly in the segments of the Real Estate Investment Trust (REIT) universe that are office-related. We have seen dramatic underperformance of those names, compared to last year, given the shift in the secular themes for office real estate. However, at the overall market level, it is almost not noticeable because it is a very small portion of the REIT universe that is dominated by office real estate names.
A falling debt to GDP ratio is a useful indicator of creditworthiness, and a number of countries seem to be moving in the right direction, says Kaspar Hense
November 2023
“Foreign ownership of the US government debt market has fallen from 40% to 30% over the last five years”
Kaspar Hense, BlueBay Senior Portfolio Manager, Investment Grade, RBC BlueBay Asset Management
Interest rates are higher than they have been for a long time, and at RBC BlueBay, we don’t see them beginning to fall for another 12 months or so. This represents a fundamental change – after a long spell when low refinancing rates encouraged countries to increase their leverage, the opposite is now true. As sovereign debt investors, we’re looking for countries that are managing this deleveraging process effectively, and one of the metrics we can look at is a country’s overall debt to GDP ratio. It’s not perfect and there can be caveats, but it is a useful guide. In the current environment, we see levels of 150-200% as a conservative number. Germany already sits in the bracket, but what other countries are in a good position to get there? Here are three countries which we think are currently on a positive trajectory.
Deleveraging is ultimately a healthy process to go through, but it can lead to disruptions, which is where we start to think about hard and soft landings. The US is currently engaging in some deleveraging, going from 260% to 250% in recent times. This is positive, as is the fact that now they own more of this debt themselves – foreign ownership of the US government debt market has fallen from 40% to 30% over the last five years. Forward rates are rising rapidly but from very low levels, so overall we at RBC BlueBay are still in the soft-landing camp. However, quickly rising government debt is a problem in the US. With 8% budget deficits and gross government debt levels alone rising from 120 to 150% in the foreseeable future, even the Federal Reserve chair, Jerome Powell, mentioned that the US is not on a sustainable path. We need to see a major reshuffle away from high cash balances and high stock ratios among private households in order to absorb net new Treasury issuance over the coming years.
United States – anticipating a soft landing
“Greece has been one of the success stories of the last decade, achieving huge deleveraging”
Greece has been one of the success stories of the last decade, achieving huge deleveraging. Their tradable (ex-EU loans) debt is now down to just 90%, having been 40 percentage points higher in 2020. And the trend continues, we foresee government debt levels to fall another 20 percentage points. Within the next six months, we expect Greek sovereign debt to be reclassified as investment grade and, when that happens, passive funds could buy up to USD 20bn. This is close to a quarter of Greece’s total tradable debt, which we believe will tighten the country’s spreads to Bunds quite substantially. The wider economic and political picture is also supportive of further progress. The green transition is working well for Greece, with solar power acting as the country’s sole provider of electricity for more than a month this summer. And the current centre-right government was re-elected in June, confirming our view that Greece will continue its efforts to reduce government debt in the coming years.
Greece – a debt success story
Sweden has learnt its lesson from a housing and debt crisis in the 1990s. As a result, they’ve come into this crisis with very low government debt (gross debt at 30%), and the private sector – which has been indeed quite leveraged – has brought its overall debt ratio quickly down from 180% to 160% in less than a year. Overall debt levels have fallen from 300% to 275% now. Furthermore, they’ve managed to do this without too much pain. That’s in large part because net assets are high – although housing assets are fairly illiquid, corporates and even households have had enough assets in stock markets and other liquid assets to help pay down their debts. Sweden’s true situation is also probably better than its debt to GPD figure would suggest. Household debt is only 85% of GDP, which is very manageable. And while corporate debt is higher, Swedish companies are very international in nature, so they’re not as levered as a ratio which Sweden’s GDP would suggest.
Sweden – a lesson learnt
Investors can be optimistic of positive returns across a range of scenarios, says Marc Stacey
“Returns are never guaranteed, but we’re hopeful of outperforming the neutral scenario”
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At RBC BlueBay, our central thesis is that interest rates are at or near their terminal peaks. Inflation is falling and although it retains some stickiness, central banks seem happy to wait for the lagged effects of their monetary policy to kick in before making any further increases. Plateauing or falling rates generally make for a positive environment in fixed income, but there are of course limits to how accurately analysts such as ourselves can foresee the future. That’s why we prepare ourselves for a range of outcomes. What’s interesting about investment grade corporates at the moment is that they look well placed for a range of scenarios, running from bullish to bearish.
“Even in the bearish scenario, the carry from where yields are currently means you can still achieve a positive return”
The following table lays out three scenarios for the next 12 months, indicating what might happen to total returns from investment grade bonds in different rate environments.
Positive returns in the offing?
As well as considering a range of outcomes, we measure our conviction on a scale from +3 (very positive) to -3 (very negative). This is an indicator of which scenario we think is most likely. At the moment, we’re at +1 for both European and global investment grade. So, we’re moderately bullish – returns are never guaranteed, but we’re hopeful of outperforming the neutral scenario. There are reasons for that optimism. First, the fundamentals are still fairly robust, and second, so are the technicals, with inflows into investment grade. The third cause for optimism is valuations. I mentioned that yields are at decade highs, and figures 2 and 3 show the repricing that has taken place. European IG corporate yields are now much higher than they’ve been at any point since 2011, and it’s a similar story in US investment grade.
‘Moderately bullish’
Figure 1: For the first time in a decade there is yield in investment grade
Source: RBC BlueBay Asset Management. Views are as at 17 October 2023 and subject to change without notice
It shows that in the neutral scenario, we’re expecting a total return of around 6.5%, based on the current decade-high yields on offer The bullish scenario feels unlikely as it would require central banks to pivot and cut rates materially. However, if it did occur then we’d be looking at a total return in excess of 10%. Perhaps the best news is that even in the bearish scenario, the carry from where yields are currently means you can still achieve a positive return of 1%.
Figure 2: European IG Corporate Yields at post Euro crisis highs
Figure 3: US IG Credit yields also at decade highs
Source: Bloomberg, ICE BofA ER00 Index, at 16 October 2023
Source: Bloomberg, ICE BofA C0A0 Index, at 16 October 2023
These higher yields are what have provided the cushion for the bearish scenario to still potentially offer a positive return and for the more optimistic scenarios to provide greater returns than we’ve seen in some time.
Figure 4: European IG Corporate Spread
We’re particularly optimistic about Europe. Figure 4 shows how spreads have widened to levels commensurate with other parts of the cycle where the world was worried about recession and other global slowdowns.
Widened spreads in Europe
In 2018, for example, there were fears around a Chinese hard landing and tightening financial conditions, while 2015 saw growth fears following the fall in oil prices. Returning to today, the stresses of the Russia-Ukraine war and its associated energy crisis have widened spreads in a way that hasn’t occurred in the US, where Treasury valuations are higher. Yet, European corporates remain relatively solid, reliable players. Indeed, IG credit spreads are reflecting default rates multiples higher than has ever occurred, both in Europe and the US, suggesting significant value is on offer.
All of this makes for a fertile environment in investment grade, across a range of opportunities. Returns are never guaranteed, but the pieces are in place for positive results across a range of outcomes.
The stage is set?
Spreads
Yields - $ rates
Yields - euro rates
Total return
Bullish
Neutral
Bearish
20bps tighter
50bps lower
25bps lower
10.2%
Unchanged
6.5%
50bps wider
50bps higher
25bps higher
1.0%
EUR IG OAS spreads at wides of 2016 and 2018 where we also had financial conditions tightening and global growth fear
A number of European countries are doing well in reducing their debt-to-GDP ratios, but some attention still needs to be paid to Italy, says Kaspar Hense
Alarm bells may not quite be ringing but the budget figures released by Italy in September were not as healthy as some would hope. Next year’s growth forecast was cut to 1.2%, while deficit targets were raised to 5.3% this year and 4.5% in 2024. It could be argued that some deficit spending is necessary in the circumstances, given that growth levels are fairly stagnant across the continent, where the shocks from Covid and energy supply concerns are still having their aftereffects. However, Italy’s numbers are higher than the EU would like, particularly its more austere northern members. There have occasionally been suggestions that Italy could lose its investment grade status, but at RBC BlueBay we consider that unlikely. Italy may still be shy of a flat primary deficit, with figures of 1.5% and 0.5% forecast this year and next, but this is still sufficient to keep its debt-to-GDP ratio stable for the time being. The only caveat would be if Italy were to lose support from the EU. However, the prime minister, Giorgia Meloni, has been notably less confrontational than her deputy Matteo Salvini. She has aligned with the EU’s stance on Ukraine and brokered EU funding to help Tunisia with its economy and to tackle irregular migration. Italy has also signalled its intention to withdraw from China’s Belt and Road Initiative, as Europe develops its own worldwide infrastructure investment project. This productive relationship should help to smooth future budget negotiations.
“Yields should remain at the higher end, with Italy’s 10-year yields reaching 5% and German bunds sitting around 3%”
Across the wider continent, we see Europe being fairly aligned with global markets. Inflation is still sticky and needs time to come down, so we think that the ECB will maintain rates at 4% for the foreseeable future. Shelter inflation, in particular, will take time to come down, and so will wage inflation, with salary negotiations generally taking place on a two-yearly basis in Europe. Yields should therefore remain at the higher end, with Italy’s 10-year yields reaching 5% and German bunds sitting around 3%. Meanwhile, the GDP outlook is not likely to significantly improve, with real growth remaining in the range of 0-1%. This means there should be long-term opportunities for investors to engage with fixed income markets. On a technical level, there is a question mark around how well the European debt market will function. In March, the European Central Bank (ECB) ended its bond purchases known as PSPP (public sector purchase programme) investments, leaving some doubt as to whether the market will find a balance with supply. The ECB will be holding a monetary review in the first quarter of 2024, and we hope that it will allow itself more flexibility to engage in the market from time to time. It does have the TPI (Transmission Protection Instrument) programme, but there would have to be a significant move on Italian spreads for that to be re-engaged.
Inflation will take time to come down
Bond yields have continued to rise in recent months, but the time to buy has arrived, argues Kaspar Hense
“We think that interest rate payments will be one of the largest expenses of the US budget over the next years”
Three years ago, yields around the world had been close to zero and we had three years of consecutive negative returns in US Treasuries, which we have never seen before. Now we think bonds are for the bold, with yields much higher than they were. The path to lower rates is still rocky, and huge returns in fixed income are still rather for the second half of next year. But yield compensation is already high, and we think from an asset allocation perspective, it is the time to buy. We expect most central banks to cut rates next year, starting with EM and then followed by developed markets.
Are we now at the top of the rate cycle and do you think investors should be looking to increase duration?
The US budget deficit is certainly ballooning and indeed concerning. We think that interest rate payments will be one of the largest expenses of the US budget over the next years. They will rise up from $1trn to $2trn and increase by 10 percentage points as a share of overall tax receipts. There is hardly any room left for discretionary spending as an automatic stabiliser, either. Discretionary spending really will become marginal to support growth. On the other hand, though, we think the market has now adjusted to these very high issuance level. Even though we think issuance will rise from roughly $1trn to $2trn next year. You also have to have in mind that there are ample of domestic savings parked in money market and in bank deposits and also in stocks. Money markets have grown to $5.5trn. Fund deposits are currently at $17trn. And domestic stocks or stocks, which are hold mainly domestically, of $45trn, give you some buffer for the supply to be absorbed. Indeed, we expect some crowding outs at these higher yield levels.
Fiscal spending is rising in the US and there have been concerns about the level of Treasury issuance that we require to fund it. Who's going to buy all these bonds?
Overall, we think that the clouds of a recessionary outlook will continue to darken the investor sky, but we think it will be rather a slow process of continuous deleveraging and low demand. Sufficiently strong or healthy labour markets and demand should keep economies afloat. Investment demand is also high in Europe and will continue to support growth, which indicates a somewhat better fiscal outlook. That means we are indeed optimistic for investment grade credit overall, though careful on sector selection. We like European banks with solid balance sheets and in our view, very manageable increases of non-performing loans. But we are still cautious on cyclicals and capital-intensive sectors such as autos.
How does leverage look for investment grade companies, and does the extra spread that investors get paid to hold these bonds over government bonds look attractive versus possible default risks?
“With refinancing rates high, we are focusing more on a bottom-up analysis than on asset allocation”
We like some emerging market local debt, where yields are still double digit but inflation is already close to target and fiscal policies have not been exuberant. We also like, as I said, European banks on the corporate side, and we think that next year US agency mortgage-backed securities will be quite interesting, with yields up to 6.5% and falling rates volatility. Nonetheless, with refinancing rates high, we are focusing more on a bottom-up analysis than on asset allocation. We do not like emerging market hard currency debt because overall valuations are not very attractive. But we like Romania, which has low government debt and trades twice as wet as the index, to give an example of our stock picking at this current juncture.
Looking at the different sectors that make up the investment grade world, which ones do you and your team think are attractive?
Markets appear to be undervaluing the resilience and profitability of European banks, says Marc Stacey
“Banking equity is now 15% of total assets, way above the 5% trigger set for contingent convertibles”
This year’s bank failures in the US and Europe sent shockwaves around the world, but there’s a danger that markets are now tarring all banks with the same brush. When we look at the European banking sector today, we see spreads that are elevated beyond the underlying risk that comes with most of the sector, and which fail to account for the profitability tailwind that is supporting it. At RBC BlueBay, we believe that European banks are in a much stronger position than markets are recognising and, for us as active managers, this represents an opportunity. We believe there could be significant alpha generated by picking the winners and shying away from the losers.
Figure 1 shows just how high spreads are for the financial sector compared to others. The distance between the blue dots and the lefthand side of the blue bars indicate that both European and US investment grade (IG) spreads are substantially elevated compared to their lowest points in the past five years – and the margin is greater than in any of the other sectors listed.
Banks look well valued and resilient
Figure 1: Developed Market credit spreads by sector
Source: Bloomberg Euro Corporate and US Corporate indicies; latest data at 16 October 2023. Note: covers a range which is meaningfully skewed by Covid wides.
Indeed, European IG financials have only been wider than they are now 22% of the time over the last five years, and US IG only 19% of the time. As such, the sector looks relatively cheap, and that’s before you come to its current profitability.
Source: RBC Global Asset Management, as at 31 January 2023
In figure 2 we can see that European bank profits have risen substantially between 2020 to 2022, helped latterly by the tailwind of higher interest rates. These profits are predicted to rise further to EUR 340bn in 2023, and we even think this might be a conservative estimate. With rates now moderating but likely staying higher for longer, the tailwind should continue to support profitability for some time yet.
The pushback we often receive is: “Aren’t banks highly cyclical? If we have higher rates for longer, won’t asset quality start to deteriorate?” Well, it’s true that tighter financial conditions and constrained consumers will lead to higher defaults in time. We may be a little way from this point as consumers will generally cut other expenditures before failing to pay their mortgages, but it is foreseeable. The bigger picture, however, is that banking equity is now 15% of total assets, way above the 5% trigger set for contingent convertibles. Prior to the financial crisis, bank equity sat at just 6.2%. Since the banks lost about 6% of their capital during the global financial crisis, they have now added back more than EUR900bn – 8.8%. So, if we had an equivalent crisis tomorrow, the banks would only be eating into the equity buffer they’ve built up over the past decade or more.
Substantial equity buffers
So, in summary, it comes down to valuations, profitability and resilience. Put all these together, and we see an opportunity that markets don’t appear to be recognising. As bottom-up investors, the next step is to identify the banks which are best placed to benefit. That’s how we sort the wheat from the chaff and construct a high-conviction portfolio built on quality.
A holy trinity
Figure 2: Higher rates boosting loss absorbing capacity. Pre Provision profits +70% in 3 years
203
248
272
340
382
103
35
42
+38
-13
163 bps cost of risk equivalent
+20 bps
Total: 183 bps cost or risk equivalent
Euro Investment grade
Financials
Other industrial
Energy
EIG
Utilities
Communications
Transport
Consumer disc
Basic industry
Capital goods
Consumer staples
Technology
Sector
5 yr range & latest
Latest
% time wider
Low
Wide
50
150
250
350
193
168
164
161
153
145
144
140
135
126
120
117
22
33
24
23
18
32
31
26
21
87
75
74
82
81
57
77
69
68
65
280
255
229
247
234
206
284
313
253
224
199
183
US Investment grade
143
136
128
125
124
111
101
99.5
96.1
19
45
67
78
63
61
72
71
93
80
83
90
76
70
378
371
392
620
298
373
383
337
322
461
331
241
Finance
Basic Industry
Utility
USIG
Industrial
Transportation
Consumer Non-cyc
Consumer Cyclical
Capital Goods
Other Industrial
95.6
66
318
“Both European and US investment grade (IG) spreads are substantially elevated compared to their lowest points in the past five years”
