Where this investor finds “bang for its buck” in global bonds

The beginning of 2024 has largely met expectations, albeit with less excitement than anticipated. The financial climate is characterised by a mix of optimism and caution, with a noticeable shift away from the gloom of previous forecasts. This is largely due to strong equity market performance, particularly in the US, and easing but persistent inflation.

The fear of missing out is prevalent among investors who've observed steady gains in risk assets without significant downturns on the horizon – that’s according to Brandywine Global Investment Management investment director, Richard Rauch.

As global recession fears subside and US inflation continues to slow, market watchers await the next US Federal Reserve meeting for affirmation of the first interest rate cut, which is widely tipped for June.

In a one to two-year period where many believe volatility will remain heightened for global debt markets, Rauch explains what his team expects from here.

In the following Q&A, he explores a region that is – surprisingly – his team’s highest-conviction investment theme currently. Rauch also discusses a couple of Brandywine’s most bearish markets, its view on the likelihood of a hard versus soft landing and delves into what could be an exciting opportunity many investors are overlooking.

Livewire: Has the early part of 2024 developed as you expected – and what does this setup mean for the rest of the year?

Rauch: Nothing ever plays out exactly as you expect. You need to expect the unexpected. It’s been close [to what we were expecting] but so far, it’s been a little more boring than many thought.

The most striking thing from conversations we had recently with clients, prospective clients, consultants, and other stakeholders in New Zealand was the element of “FOMO” that’s going on. Even just six months ago, people were still expecting a hard landing – things felt pretty awful.

That sentiment changed through the back part of last year. Part of that is because equities just keep powering ahead, driven by the US. Inflation has dissipated, although it's a bit sticky, and credit spreads have just ground higher. So, if you haven't owned risk assets, you've really missed out and people can't see anything on the immediate horizon to change that perspective.

Looking ahead, everyone might be saying “oh, there's going to be something crazy that happens and it's going to jolt markets.” But more often, things just tick along.

Growth is usually good. There isn't a catastrophe in markets. For example, GFC events come along only once in 100 years or so, not every two years. So, we've been telling clients not to overthink it.

This might just be the year of the coupon. What does the year of the coupon look like? That just means that nothing happens in bond markets, and you clip your coupon all year – which isn’t a bad outcome!

In bond markets, your return expectation base case should always be what your yield is on the bond. As active managers, we hope to do better than that – there’s good reason to believe bond yields could fall and provide a capital appreciation kicker. But over the long run, there's a very tight correlation between your yield to maturity on a bond and your forward-looking return expectation.

So, right now, bond investors actually HAVE a coupon again. US treasuries are yielding around 4.25% to 4.5% and got up to almost 5% last year – and that's without taking any credit risk.

Livewire: What’s your rationale behind some of your current portfolio positioning, for example, in Brazil, Mexico and Colombia?

Rauch: Latin American sovereign bonds are one of our highest conviction views and were among our best-performing positions last year, and we still hold that.

As you see in the chart below, our universe for sovereign bonds is between 30 to 40 countries. For each, we subtract trailing 12-month inflation [to get the real yield] – which is a crucial part of our bond and country selection process.

insert chart

Real yield could be high for a good reason – for example, maybe inflation's going to re-accelerate. But in simple terms, you want to own high real-yielding markets and not those with low or negative real yield.

Rewinding the clock to 2021, it was grim. Most of the ponds we were fishing in had negative real yields, which meant we were more limited in what we could focus on.

Now, a lot of global markets are offering positive, real yields. And on Latin America, it’s quite simply a valuation story for us. A lot of these countries have the highest real yields in the world.

The macro story there is simple…Latin American central banks started to tighten interest rate policy a year before developed markets did in 2022, because they just couldn’t afford not to. They didn't wait for a balance of payments crisis before they addressed their inflation problem. As a result, they’re now on the other side of that cycle. Countries like Brazil are cutting rates.

Each country is a little bit unique. For example, Mexico is an investment-grade market. It benefits from the whole “friend-shoring” initiative in the US and in many ways, is a very big and developed market. But more broadly, maybe Argentina notwithstanding, they have gotten their fiscal houses in order. We think they’re on the right side of the inflation story.

We think inflation is going to keep going down in these countries. It's a no-brainer. 

So, you think you benefit in multiple ways. You've had two tailwinds: The bonds have performed, you've had the “carry”, but you've also had the currency appreciating in these countries. We think that's going to continue.

Livewire: On the other side of the coin, which global bond markets are you most bearish on for 2024 and why?

Rauch: That would be Japan. It has an inflation problem right now, which they haven't had by any means for around 30 years when they had no inflation – the central bankers are probably high-fiving.

Depending on what measure you're looking at – let's say they have a 4% inflation rate –their policy is totally wrong for that. And they're manipulating their yield curve, having come out more recently and kind of indicated that they're going to back off on this yield curve control policy. We think that's inevitable at some point.

We think their bond yields are going to go up. We think they're going to have negative returns in Japan, they have a very low outright yield.

We also don’t have any exposure to China. We might've missed out a little bit but there's a lot of bad news priced into China more broadly. The surprise here might be that China outperforms, which probably means a negative for their bond market, but a positive for their equity market.

Livewire: Many macro commentators believe heightened volatility in bond yields has now entrenched. What is your team’s view and what does this mean for fixed-income investors?

Rauch: On the whole debate about whether we’ll get a hard landing, soft landing, or no landing, I’ve heard it explained like this: soft landings are like giant squids. We know they exist, but you rarely see them.

That's our point around soft landings: a hard landing looks like a soft landing until it doesn't. And this is the $10 billion or $10 trillion question. A soft landing is the base case for almost everyone now but are we just on our way to a hard landing, ultimately?

Talk of a no-landing is also gaining more traction. “Oh well, maybe we just re-accelerate to a new cycle, inflation takes off, and growth continues to power ahead.”

Our view is that a no-landing scenario is just a hard landing postponed. It just means central banks are going to be so tight for so long that it's going to be very painful when it all comes crashing down.]

Livewire: Outside of sovereign bonds, which types of corporate credit are most attractive now?

Rauch: Credit has probably been one of the most interesting parts of fixed income for the last 12 to 18 months. And it's kind of defying gravity.

You would've been best off a year ago just holding your nose and buying high yield, and you would've had one of the best-performing areas of fixed income if not capital markets – short of Latin American emerging market, local bonds, and US tech.

The debate, at least, we've been having is what is more important: the outright yield or the spread relative to the risk-free rate? The second one is usually what people focus on when they're talking about credit. And this is why spreads weren't that attractive even a year ago. There were a lot of concerns about the macro-outlook and a hard landing going into last year.

What’s played out has seen the yield remain much more important.

And the third stat is the dollar price. And without getting too technical here, bonds and yield prices move in opposite directions because government bond yields have gone up so much. The dollar price of all these, even corporate bonds, has fallen. That is a nice buffer for a default because you’re only at 80 cents right now – you're not at a hundred going to 60 or something similar. The all-in yield and carry are very high, which means the perspective outlook for returns is quite high.

The final thing is the inversion of the yield curve, meaning at least in the US, if not other markets, short-dated bonds have been yielding higher rates than longer-dated bonds, which isn’t exactly sustainable. That means you can get a nice bang for your buck just by buying short-dated, high-yield bonds.

One final point around fundamentals is that companies can't default, not really, unless they must pay the money back. So, they've pushed out a lot of these maturities. And then if you look at the actual fundamentals, for example, interest coverage, outright debt levels, and capital structure. Is it high up or lower down the capital structure?

Conclusion: "Credit is still pretty darn good"

The overall credit quality of the market has gone up, at least in high yield, and we think that's being absorbed by the unlisted space, private credit. Maybe that's the next source of volatility or leverage in the system – but it might not be systemic. Because it's just tucked away on pension funds and insurance companies or asset managers’ balance sheets.

In public markets, that leaves credit still looking pretty darn good, even though spreads are at cyclical lows and there's just nothing on the horizon that worries us from a default perspective right now.

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Brandywine Global Opportunistic Fixed Income Fund

Global Fixed Income

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