• Investors should focus on the long-term impact of rate cuts on their bond portfolios, rather than trying to time near-term market movements.

• Lower interest rates should benefit EM bond investors, but a global economic slowdown would hit EM bonds faster and harder than other areas of fixed income. 

• Overall, corporate fundamentals remain strong but there are challenges ahead, especially for high-yield issuers facing higher refinancing costs in the months ahead. 

1. Think longer-term about rate cuts – and look for resilience

Sarang: Our approach doesn’t really rely on short-term movements in rates, which is very difficult to execute. Markets have already priced in several future cuts, so as an investor, we’d have to be positioned for them far in advance - and that’s very challenging to do in practice.

In a global fund like ours, there are longer-term ways to play falling rates, like investing in out-of-favour pockets of the market that stand to benefit from a lower-rate environment. At the moment, we really like high-quality European REITs¹, which sold off back when rates were rising, and are now trading at attractive levels. 

I think we're at an interesting point in the rate cycle from a portfolio construction perspective. Until recently, investors could earn a decent level of income on cash and didn’t really need bonds in their portfolios. But as policymakers cut rates, that’s going to change quickly. Whereas in bonds, the impact of lower rates will take longer to filter through; investors can still earn attractive levels of income even as interest rates are falling. 

Nick: Generally speaking, rate cuts are good news for EM (emerging market) bond investors. But we always need to consider why rates are being cut. If we begin to see policymakers cutting rates into a rapidly-slowing global economy, that’s categorically bad news for EM bond markets, which are more likely to sell off faster and further than other areas of fixed income. 

Given the economic uncertainty, we favour EM stories that have a bit of resilience to them, like higher-quality sovereigns and EM investment-grade credit names. In EM high-yield, we are seeing impressive returns from a number of newly-restructured sovereign issuers. Some of these countries’ bonds were trading for pennies on the dollar a few years back before their restructurings - but have since delivered significant gains for bondholders after successfully restructuring their debt.    

2. Fundamentals are solid – but be aware of challenges 

Sarang: Broadly speaking, companies are in good shape, but we are watching closely for signs of a downturn. 

If we think back to last year, markets were focused on the risk of a recession which, as it turned out, never materialised. Yet the underlying concerns haven’t gone away and are just taking longer to play out. 

Looking ahead, we see some challenges on the horizon. Funding costs for high-yield issuers are particularly concerning. Many high-yield bonds that were financed at much lower rates are starting to come due this year, which could lead to significantly higher funding costs for those issuers, which in turn could put pressure on profit margins and lead to a deterioration in credit ratings across the asset class. 

Nick: Fundamentals among high-quality EM issuers are also looking robust, yet a lot of this is already reflected in their pricing, and spreads are historically tight. 

At the high-yield end of the EM spectrum, the ‘mid-block’ EM sovereign issuers are still in good shape, with many receiving support from the IMF and World Bank. These multilateral institutions have increased their lending capacity in recent years. Egypt, for example, has a robust IMF and World Bank programme, supported by meaningful financing from the UAE as well. 

There's always going to be a few areas of weakness. Kenya, for example, has recently come into difficulties. The distressed names that are coming out of debt restructurings actually look relatively good because they've recently finished refinancing negotiations that include fresh support from the IMF and World Bank programmes. 

There's always uncertainty in EM, but where there's uncertainty, there are potential opportunities for mispricing.

3. Take a deliberate approach to beta

Nick: At its core, our ‘deliberate beta’ approach means we make portfolio decisions based on their sensitivity to underlying benchmarks. 

While we appreciate there are points in the cycle where we may want to deliberately increase our portfolio beta, it should never be done in an unintended way. This is completely opposite to many hedge funds, which often try to time markets by taking big macro-level bets on key turning points in the economic or monetary cycle. 

Unfortunately, history has proven time and again that most active managers aren't very good at timing markets. They may be good for a year or two, but then they may be terrible for the next five years. And that's not a great outcome for investors. 

Ales: In Europe, we see certain opportunities to be more deliberate in our beta exposure, particularly in periphery countries that have seen much higher rates of growth than the core European markets. Traditionally, investors have viewed Germany and France as the engines of growth in Europe. But that’s changing, as countries like Spain, Portugal and Greece, which benefit from more services-based economies, have experienced strong growth compared to more industrial-based economies like Germany. 

4. Focus on selection – and diversify alpha sources

Ales: When it comes to interest rates, we like to say that monetary policy goes up by the stairs and down by the elevator, because central banks are usually behind the curve in making changes. But this time around, central banks have been more proactive – but that could change quickly if recession risk rises. 

Nick: Investment-grade EM can provide attractive longer-dated yield opportunities, and that can really matter through the cycle for investors. It’s much harder to get the same kind of duration and spreads in traditional investment-grade bond markets. Of course, there's downside risk to EM, which needs to be properly managed with the right risk controls in place. Manager selection is crucial to getting the most out of the EM asset class. 

Sarang: My message is the same one it’s been for the last seven years – style diversification matters for active credit investors. Being able to tap into diversified sources of alpha within the capital structure and across credit markets has proven to be much better than trying to time markets - and has helped us deliver consistently strong returns for our investors. 

¹ A ‘REIT’, or real estate investment trust, is a company that owns, manages or invests in a portfolio of real estate assets. 

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