Peter Marsland: Welcome to abrdn's Fixed Income Explained podcast. I'm your host, Peter Marsland, a fixed income investment specialist at abrdn, and today we'll be addressing uncertainty. We will discuss factors that could be currently influencing investor sentiment, and also our key investment themes for the remainder of 2023.

Joining me today is Ken Akintewe, Head of Asian Sovereign Debt, Jamie Irvine, Investment Director within our credit team focused upon investment grade Sterling bonds, and Aaron Rock, Investment Director within our Rates Team focused on UK government bonds. So, a good breadth of expertise to cover the investment landscape. Welcome, everyone and thank you for joining me today,

So, let's start off with a nice, easy, quick-fire round, that requires a relatively short answer. In your opinion, what is the most significant factor that will influence your particular market over the next 12 months? And let's kick that off with you, Aaron.

Aaron: Thanks, Peter. So, in a single word, it would be inflation from my side. Just to draw that out a little bit. As a government bond investor, the foundation of my investment view is the macro-economic environment. So big picture stuff - growth, unemployment, fiscal monetary policy. And I don't think there can be any doubt that over the last 12 months, the rise in inflation has dominated that landscape and influenced every one of those factors. It's my view that over the coming 12 months that inflation will continue to be the dominant force. However, it will be the debate over how rapid inflation declines from here that will now dominate, and also how dogmatic the central banks will be in their pursuit of 2% targets. So, there are many other factors to consider. But for me, inflation will be the driving force and have profound consequences for the global economy.

Peter: Yeah, I think that's something that's probably on the tip of everyone's tongue at the moment in terms of what are the key factors. Jamie, what about your particular market?

Jamie:Thanks, Peter. So, I could relate to everything that Aaron has, of course, just mentioned there, particularly with respect to the UK. And when we're, we're looking at the credit health of, of UK companies, UK corporates, and UK households. I think as a direct corollary of what Aaron has just said, in my very short answer, it would be restrictive lending conditions. We still have yet to see the pace and extent to which these feed into the real economy and the subsequent impact thereafter on households and corporate borrowers. That would be my brief tuppence worth.

Peter:And if we were to broaden that out looking at this in a global context, what are your thoughts, Ken?

Ken: Yeah, thanks, Peter. Obviously, my team invests in the Asian fixed income markets, both the macro - primarily local currency government markets, as well as the credit markets as well. Somewhat linked to those two topics, I mean, we would think that the growth environment is probably going to be the most important factor not just for Asia, but obviously, we're a part of emerging markets and fixed income markets as well. And the nuance there will be that obviously, there's a very strong focus on, you know, potential recessionary risks, as we go into the second half of the year, and these have differing impacts on the emerging market landscape.

On the one hand, you know, a relatively shallow recession could end up being positive because they'll take the foot off the policy normalisation cycle that is going through some of the developed markets and this continued increase in funding rates, that has put pressure on some of the emerging world and could end up being quite positive actually, as that cycle rolls over. On the other hand, a deep recession in the global environment could end up being quite negative with many different sort of paths that that could affect the emerging markets and Asian markets, you know, the commodity channel for some of the broader emerging markets, and of course, the export and trade and growth cycle for the exporting sort of Asian economies.

Peter: Yeah, thanks for that gentlemen. So those are sort of the headline drivers. What are the other key factors you are currently considering when you're managing portfolios to generate positive returns?

Aaron: So, from, from my perspective, Peter, you know, given what I said before about considering things from the macro environment, I guess we start from a global context. And I guess the good thing about looking at things from that macroeconomic environment is there's always something to be you know, have a view on, or something to look at and to study and research and you know, in a global context in the very near term is probably quite topical for a lot of listeners.

We're thinking about the US debt ceiling debate. And whether that gets resolved some of the potential fragilities within the US banking sector, also the outcome of the war in Ukraine, particularly, its impact on food and energy markets. And, of course, the transition to a net zero economy. So those are some of the things in a global context.

If we zoom in a little bit closer to home, you know, I manage UK government bonds. And in the domestic context, I would pick out the likely path for the Bank of England in terms of monetary policy, are we nearing peak policy rate. Also, on the on the political side of things, we know that we have to have a UK General Election at some point next year. So, we need to consider the changes in fiscal policy that that may entail if there is indeed a change in government. And then also, I think, crucially, for the next six months, in particular, will be the impact of refinancing within the UK mortgage market. So, for us, that is a particularly interesting topic, and one which will have significant consequences for the Bank of England.

Peter: Okay, thank you Aaron. And, Jamie, what are you considering, from a credit perspective with an outlook over the next sort of six to nine months?

Jamie:Thanks, Peter. Well, again, as a credit investor, what Aaron has just described in the political and macroeconomic environment, that's of course crucial for us. But it's also very important that we need to consider what valuations are reflecting at that stage in the credit cycle, and at this stage in the economic cycle.

So, credit spreads in sterling investment grade, on average, about 180 basis points. And that is pricing in some recession risk, if you look at pricing from a historical perspective, and with yields nearing 6% on a yield to maturity basis.

But we need to be quite selective in where we allocate that risk. As Aaron has alluded to, the UK has seen 12 consecutive rate hikes from the Bank of England. But they've also nearly completed their sale of around 15 billion pounds worth of corporate bonds, which they built up during the pandemic as an emergency liquidity measure. So as this tightening feeds through, we need to be wary of sectors and issuers which are perhaps more leveraged, or are more sensitive to increased cost of capital and increased cost of financing. For example, the real estate sector, that's one that has been well storied, over the past few months, and particularly commercial property, not just in the UK, but in the US and across developed markets.

So, the credit spreads of these issuers, they've been hit more severely due to concerns on declining asset valuations, higher borrowing costs, but something that we consider as credit investors is that not a homogenous sector and there are differences between issuers. You know, there are opportunities among many good operators, which are more conservatively levered, have high quality assets, don't have any impending maturity walls, and they have spreads that can be quite compelling or unjustifiably elevated.

Similarly, if we look to the banking sector, as we know, has been very storied over the past few months, with the events among the US regional banks and the eventual demise of Credit Suisse. Something to consider, most bank debt in UK investment grades, it's from large UK or large European or the major globally systemically important US banks. So, the senior high-quality debt of some of these larger capitalised names remain at very discounted spreads. And it's, we've not seen in Europe and UK, there hasn't been the same deposit flight as has been seen in some of the US regional banks. It's also important to consider that the UK credit market, it's not homogenous UK-specific risks. It is quite diversified, nearly 50% of the investable universe is actually from corporate borrowers based outside of the UK. So, we actually think that - despite the more difficult macroeconomic picture - there are plenty of opportunities and we have a lot more dispersion in credit spreads and in volatility, which we think presents us good opportunities, provided you take a selective active approach and remain appropriately diversified.

Peter: Yeah, I think that's a, that's a really good point you make Jamie about the increased volatility within markets at the moment is often beneficial to active managers who can, like you say make good, informed decisions around where to be exposed differently to the benchmark to try and add value. So, I think that's a really valid point. And Ken, what are the other things that you are really sort of considering on your investment horizon at the moment?

Ken: Yeah, I mean, thanks, Peter. I mean, there's, there's so many factors to look at. But really, if we were to aggregate them, it's about thinking about how the variety of markets within the region will perform in the kind of environments that we're thinking about. For many of the central banks and economies in the region. Actually, they're already hitting sort of peak cycles in inflation and monetary policy already sort of last year. And so, you know, the gaze is already shifting away from inflation towards some of these growth headwinds. And we're starting to anticipate that you'd get the first central banks beginning to cut rates over the next few months, and certainly towards the end of the year. So, trying to identify where that maybe hasn't been priced in and position in these markets, where to be honest, for several years, as you went through this inflation and monetary policy cycle, you want it to be very light risk, and then suddenly, you have value created across the region in markets like Korea, even in the Philippines, in Indonesia, and really a very broad diversified opportunity set.

And then, of course, there's the focus on you know, just in case there are those downside risks - which markets are more resilient. And typically, those are the more idiosyncratic markets. We have very much over the last decade or more gone out of our way to find trades and investments that other global investors don't own. And these are typically markets that may be difficult to access, or global investors are not familiar with things like the Chinese domestic fixed income market, and the Indian domestic fixed income market, because that allows us to avoid one of the biggest shocks that tends to hit markets, which is that outflow of capital every time there's some kind of shock to the global economic system. And these trades have really performed exceptionally well. Over the last few years, they've really been key drivers of actually delivering strong performance through these shocks we've seen in 2018, 20 and 22. Somewhat surprising global investors, given some of the shocks have actually emanated in a way from Asia, the Asian local currency markets have actually delivered pretty robust positive returns over the last three years, five years, particularly for a sterling based investor where you might look at Asian FX risk in a sterling Asia sense.

So those are some of the things we're looking at, the idiosyncratic nature of markets, the sensitivities to some of the global risks, there are other factors as well, that may be a little bit more short-term. So, for example, we are in a very high seasonality period at the moment with a tendency for dividend repatriation, outflows coming from some of these markets, which puts additional pressure on some of the currencies. But we can actually use that as a better entry point to take risk in, in currencies like the Korean won, the Philippine peso. So numerous kind of structural, medium term and long term, as well as some short term factors that we can focus on in terms of being able to capitalise on better valuations in these markets.

13:08

Peter: I think that's a fantastic point you raised there, Ken, is that for domestic investors that are say, UK or European based, it seems like obviously you've gone through a lot of pain last year, with the increase in government bond yields that we've seen and central bank starting to hike. But obviously, in other parts of the world, such as Asia, there are countries that are going through a different part of the economic cycle, they've already gone through that hiking part. And they're actually starting to see the interest rates and bond yields actually come down, which is in contrast to what we're seeing in the West.

So, taking that broader sort of global approach, you can certainly see other interesting opportunities emerge as an investor. So, taking that bigger view of the opportunities and the landscape available, can be quite key at a time like this, I guess. Okay, so I think one of the things that's been quite interesting at the moment is that given that, that bank rates in the UK and Western markets have increased as governments respond to the high inflationary pressures that we've witnessed, cash rates are actually quite attractive. So, the old saying that cash is king appears to be resonating with investors and a lot of investors effectively sitting on the sidelines and holding cash, because it now does offer, you know, a positive nominal return, which in a sense, is risk free. What would you say to investors today to try and tempt them away from that sort of risk-free asset class into your particular area of the investment universe? Let's start with you again Aaron.

Aaron: Yeah, it's an interesting concept. And you know, it's something that we've observed as well is that is that buildup of cash and investment into money market funds in particular over the last sort of three to six months. And I guess, in some respects it’s no surprise given that for a decade or so following the great financial crisis, investors had become conditioned to cash being a zero-yielding asset. You mentioned cash is king, certainly for 10 years, I can remember the phrase being ‘cash is trash’, because effectively it was a zero-yielding asset. So, when investors see a yield now on offer, say in the UK of 3, perhaps even 4%, it's attractive. But I think there are some things which need to be considered within that.

I think the first is that it is a nominal rate of return. So, it offers zero protection against inflation. So, it's great that you're receiving a 4% nominal return. But if inflation is 8%, then that doesn't stack up very well as an investment. For me, I tend to view cash as perhaps more of a staging post for investors who may be on a journey from one asset class into another. So, for me why what I would say is given the level of the risk-free yield on offer and some government bond yields currently, if we take the UK as an example, we’re trading around that four to four and a half percent nominal yield in government bonds. And I guess what they offer you that cash doesn't is an element of duration sensitivity.

So just to explain that a little bit further, should it transpire that the central banks have perhaps over tightened policy this year, we go into a little bit of a slowdown in the second half of the year, and they're forced to cut rates, as rates fall, holding those government bond assets would give you an additional capital return, that would not be the case, if you were in the cash, if you were holding cash at that point, you would just be beholden to that lower rate of return on offer. So, for me, you know, I look at where we are in the cycle. I believe we are approaching peak rates in terms of monetary policy. And I see those risk-free government bond yields, particularly in shorter dated maturities as offering good value here for investors, either in the nominal sense, or perhaps even in short, dated index-linked government bonds, which have had a torrid couple of years. But to me, look, look reasonable value here.

Peter: Yeah, no, I think, I think that's definitely something worth considering. And, Jamie, what about you in terms of credit?

Jamie: Yes, I’d agree with everything we've discussed so far, that cash has certainly become more compelling. It's difficult to argue with that. But I think in the UK, you still achieve what to me is quite an attractive pickup by investing in credit.

Using a very anecdotal example, I get just over 3% interest on my instant access bank savings account. I won't tell you which, which bank that is. But I think that is one of the best in the market from my research. But I compare that to around about 6% yields I can achieve in a short, dated corporate bond fund, for example, which also has the opportunity for capital growth. And we think that is a great alternative if you are more conservatively minded, or you’re minded to take shelter in cash. I think you know, we have discussed that cash is in inverted commas ‘risk-free asset’, but it is only risk-free to the extent that you're not suffering elevated levels of inflation.

Short-dated bonds, we define as investment grade corporate bonds, so high quality, credit risk, that mature within five years. So, they also have much lower duration risk than a typical bond fund. And hence, historically, these bonds have traded at lower yields. If you look on average over the past 10 years, about 75 basis points lower than a normal maturities corporate bond index. And with short-dated credit, having more visible earnings, visible cash flows over the shorter timeframe, they've tended to trade at tighter spreads than bonds with longer maturities. But we're now in quite an interesting and rare environment where you can achieve both the yields and the spread pick-up from short-dated bonds versus bonds across all maturities. And so, we think that's a very compelling area. Again, we would suggest that you need to be selective in your credit exposure. If you take a closer look at the short-dated index, for example, over 50% of that universe is in banking bonds. So, you want to make sure that you're picking the issues you're comfortable with, and that you're appropriately diversified and selective.

Peter: Thanks, Jamie. It does seem quite a while since we've actually managed to say that the yield you can get on short-dated sterling credit bond is, is about 6%. So, it's certainly a lot more of an attractive entry point than it was many years ago or in the most recent past anyway. But Ken, 6%, I'm sure that seems quite meagre offerings to what your region could potentially offer?

Ken: Yeh look, I mean, there is a time and a place for holding cash, I think Jamie touches the point that inflation sort of erodes the value of, of that cash quite a bit. But you know, at a certain point you want to be, you know, if you've got strong investment discipline, you want to be deploying that cash when markets are cheap, rather than waiting for markets to get expensive, and then deploying that cash.

And the fact is, we've been through one of the most torrid environments, particularly for emerging markets. And, you know, if I speak more broadly than just Asian fixed income, you know, many parts of the universe are trading at attractive levels, and some of the risks that have been faced by the asset class, you know, have started to fade into the background. So, for example, if you're holding dollar assets, whether that be dollar-denominated credit or sovereign bonds. One problem was initially when you're in the early stage of the Fed’s hiking cycle, the US Treasury rates erode a large part of those returns. But now that we've been seeing treasuries sort of peaking, you no longer have that underlying drag on these dollar-denominated assets. And the spreads are still at pretty attractive levels. I mean, sovereign spreads are still, you know, close to a 500 spread. So, the yields are quite attractive.

If you really have risk appetite, you know, there are far frothier parts of the investment universe, like the frontier space where that market is trading at historically very, very cheap levels. But obviously, that is a very long term trade, because it's going to take a while for global growth, to return to levels that will allow these small, more vulnerable economies to really see the kind of economic recovery that will drive the kind of socio economic and other positive changes that take them away from this sensitive environment that they've been in.

You know, other than that, I mean, I think if you look across into the regional equity markets, because of the sort of Asian-centric nature of some of the risks that have been faced, you know, you're seeing opportunities to buy some of the equity markets in Asia, at price to book levels of you know, one times, or slightly above that, you know, they're trading at very cheap levels. So if you're not deploying cash in this kind of environment, where if you take a medium term view, we will see a recovery and growth, you know, it may be coming slower than some of that anticipated, but China will eventually reopen more strongly, and that will provide uplift to regional markets as those intra-regional flows from China start to emerge, then, you know, you'll be missing out on some of these really key opportunities. And that's before we get into some of the nuanced opportunities, sort of, like technology and maybe renewable, sustainable parts of the asset class.

Even in the environment we've been in, some of these markets have performed very strongly. So, for a sterling investor, you'd have had, you know, a 30% return, say, from the Indian bond market over the last five years, right. So clearly some very strong opportunities. And then if we think about, you know, that particular opportunity set, central banks could be easing policy rates by about, you know, up to 100 basis points over the next 12 months. So, valuations are still attractive, because that is not priced in, so not only can you get attractive, carry slightly above 7%, but there's the capital gain, as well, that can be achieved, as well as the yields come down in that market. So, you know, we think you should definitely be sort of hunting around and trying to identify some of these better, you know, risk adjusted opportunities, and obviously, some of them are dependent on investor's risk appetite. But across this investment universe, there is an asset class to fit the most conservative investor, and the most risk seeking investor that will offer value and probably give much stronger returns than cash over the medium term.

Peter: I think that's a, that's some really solid points there and highlighting the danger of just sitting on the sidelines effectively. And, you know, not taking advantage of the opportunities that are out there, you know, could be something that's detrimental to overall investment returns to people that just sit in cash over the next sort of six to nine months. Well, thank you for that. And let's wrap this up quickly, with a quick fire round to finish with. So finally, is there anything that's keeping you awake at night? And let's actually start that with Jamie.

Jamie:I'd say my fixed rate mortgage deal expiring in November is keeping me, is giving me some sleepless nights and I need to ask Aaron where he thinks rates will be then. But on a serious note, I guess I'm just one example of the many mortgage households in the UK that have yet to see their rate change, since the Bank of England started hiking rates. And I think we have around half of households with a mortgage have yet to see their rate change rise. So, it's you know, certainly I'm conscious of what that will mean for my disposable income, come later this year. And I know I won't be alone. And thinking that and we know, that is ultimately the transmission of monetary policy happening in real time and being able to witness it. From my own personal view, as well as from my investment point of views, it’s going to be quite an interesting journey. And, yeah, this is where Aaron's going to tell me whether I should fix for two years or fix for five, or go for a variable rate.

Aaron: I wish I had that answer, Jamie. And actually, I mean, what you've just said, is the thing that I think from, from an investment perspective that, that is keeping me awake as a UK government bond investor on it is that, in fact, that lagged impact of monetary policy tightening feeding through, particularly within the UK mortgage market, you know, it's something we've done a lot of research on lately, and there has been a fundamental change in structure within that UK mortgage market.

Prior to 2010, about 40%, give or take, of the UK mortgage market were on fixed rates. Now around 85% or more of the stock of mortgages in the UK are on fixed rates. And as you mentioned, Jamie, what that means is, the transmission mechanism for the Bank of England has got longer, it takes longer for their monetary policy actions to feed through to households and businesses, and in this case, UK mortgage holders. So, our estimates indicate that in the second half of this year, there will be around 150,000 fixed rate mortgages per month coming to an end, which will need refinancing. And most of those are actually sub 2% at the moment. So, you know, those households are going to see a significant increase in bills and a significant decrease in disposable income in the second half of the year. And we are concerned about what that means for economic activity. And we think the Bank of England should be mindful of that when considering their next moves in the policy rate going forward. So, you're, you're a prime example of what is keeping me awake at night other than the prospect of Manchester City winning a treble. For a Manchester United fan like me, that is a very, very scary thought.

Peter: I can completely echo that sentiment Aaron from an Arsenal perspective. Just actually on that changes in the mortgage rates and the impact that will have on consumer behaviour. Is that likely to impact the demand side of the inflation equation potentially, which could help as a dampening effect on inflation prints?

Aaron: We think so, yes. I mean, we're speaking on a day when UK inflation has been released, and there was a slight upside surprise versus expectations. So currently, headline inflation is 8.7%. We do expect that to continue to decline throughout the rest of the year. And yes, I think that that erosion of disposable income, that hit to real household incomes, we think can weigh further on that, particularly from as you say, the demand and consumption side. Households will have to allocate more of their income to non-discretionary items. And that will surely slow down the economy. As I said before, we think that's something that the Bank of England are aware of but are slightly frightened of being too vocal about at this juncture. And given that their major concern has to be inflation.

Peter: Definitely. And finally, Ken. Sorry – Jamie, you want to add something to that?

Jamie: Well, I can relate that also from just what we're looking at, from a credit perspective, where it's very clear that mortgage payments are going to rise for a lot of people, and that is going to weigh on their disposable income. But as yet, that's falling short of people going into losing their incomes or are finding themselves unemployed, which, in previous, you know, deeper, more severe recessions or financial crises, when we look at banks, asset qualities and banks earnings. Banks right now aren't too concerned about people having to pay more for their mortgage, they've done a lot more to assess their affordability, loan to value is much more, much lower than it has been in the past. And overall, from taking a very high level view using me as an example. You know, I'm, I'm still going to be able to afford to pay my mortgage, you know, come the time that the rate does rise in it, provided I still have a steady and reliable income. And so, we've not yet seen that feed through and into deeper unemployment in the UK. We're still relatively comfortable with the overall corporate picture and the overall strength of corporate balance sheets and particularly, you know, some of the more mortgage, UK mortgage exposed issuers.

Peter: Yep. Thanks, Jamie. Finally, Ken, anything keeping you awake at night at the moment?

Ken:I have to be honest, Peter, I actually am blessed with sleeping very, very soundly at night. I don't know why that is, maybe it's because I'm a strong advocate of meditation, which I strongly recommend to anyone, but particularly investors, you know, being able to keep a calm mind through what can be quite volatile cycles. It could also be because, you know, I was born in Aberdeen, in Scotland, you can tell by my accent, or indeed by my surname, but I spent the last 20 years living in Asia. And over here, we're blessed with relatively prudent governments that tend not to make the same kinds of errors and mistakes that you see, not just in EM markets, but as you know, living in the UK, some DM markets as well. Very high trust in government over here. And more importantly, they tend to have this tendency to learn from crises, so the region goes from strength to strength over the last two decades, and so that makes you have the feeling that, you know, everything will kind of be alright, and the end of the day, they'll do the right thing. And you'll get through these things in a stronger mindset.

It could also be because I kind of follow the Dalai Lama’s sort of thought that, you know, if a problem is fixable, then there's not much point in worrying about it. And particularly when it comes to investing, most problems are fixable, you can always find a way to shift your asset allocation to avoid a problem. Or indeed, if that problem happens, then you can take advantage of you know, beaten up assets, valuations, that will happen. So, you know, for all those reasons, I sleep quite soundly, but I have to say we did just get a new puppy that seems to have taken to barking at nighttime so every now and again, that sort of will wake me up during the nights.

Peter: Thanks Ken. So aside for the puppies barking, I think that’s a good way to conclude the podcast on that very uplifting and upbeat note from Ken about solving investor problems. So that concludes this episode of abrdn's Fixed Income Explained podcast. And I hope we've managed to provide, you know, a degree of clarity to these uncertain times and to provide our views on what's likely to transpire over the sort of next six to nine months of the investment horizon.

And it just finally goes for me to thank our guest speakers for their contributions. So, thank you very much, everyone. And if you'd like to find out more about our fixed income views, you can subscribe to our fixed income newsletter by clicking on the link below. You can also listen to previous podcasts by clicking on the other link below. Finally, thank you for listening and goodbye.

Disclaimer

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer investment recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors make it back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.