How credit can optimise risk & return payoffs in Global Fixed Income Portfolio

Abdelak Adrjiou, manager of FP Carmignac Global Bond and Carmignac Portfolio EM Debt portfolios, continues to advocate active credit selection and management to optimise returns and manage risk within his funds.

Credit is one of the three pillars that Abdelak considers driving investment returns, alongside Duration and FX exposure. Within this space, Abdelak considers all spread assets, from corporate credit to sovereign credit (hard currency external debt)¹.

In this article we will explore how Abdelak considers credit decisions and reference the current opportunities that he and his colleagues in Paris are seeing.

As inflation took hold on the global economy and central banks entered in 2022 a period of sustained tightening, bond yields and credit spreads both experienced significant selling pressure; however for the last two years, corporate debt markets have enjoyed significant positive returns with spreads tightening strongly, adding to the compounding effect of carry and providing positive total returns across the different types of credit classes. We have observed credit indices returning from 3% to 10% on an annualized basis since June 2022 (across corporate and sovereign credit indices).

This is demonstrated by the chart below showing movements in Sovereign hard currency external debt and European Xover spreads. It appears that the Itraxx Xover spreads have declined from 650 bps in H2 2022 to around 300 bps today. In fact, 2022 was marked by increasing concerns about inflation, central banks raising interest rates, and a significant widening of risk premia, resulting in wider credit spreads. However, as inflation showed signs of moderating and the global economy remained robust throughout 2023, credit spreads for both corporate credit and EM hard currency debt began to tighten steadily. We saw renewed economic resilience, particularly in the US; default rates were more resilient than initially feared, and credit spreads were supported even as interest rates continued to rise. As we work our way through 2024, we can see that the environment has been a continuation of 2023, with the same dynamics entering to play.

Similarly, the spreads on emerging market sovereign debt followed a similar trend, tightening from 600 basis points to around 350 basis points until April 2024. This tightening was driven not only by the overall economic recovery and decrease in inflation in these countries, but also by specific events in each country. For example, countries that export commodities benefited from high commodity prices, which improved their fiscal positions and trade balances. Additionally, countries that secured IMF programs also saw improvements in their credit spreads, for example Egypt, was one of the top performing issuers in 2024. Furthermore, improvements in politics and governance and successful debt restructuring programmes, as seen in Argentina or Ecuador, also contributed to the tightening of spreads. (However, in the short term we have observed spreads increasing slightly due to elections and more country-specific factors).

The level of risk premium across credit segments has now returned close to 2021 levels and we observe that spreads are not as attractive at the index level. However, bond yields are at much higher levels, with carry now contributing much more to bond returns. Historically the combination of low bond yields and low credit spreads have been disadvantageous for the asset-class, but the current higher-yield environment means that credit can act as both a kicker for investor returns and a cushion for volatility.

So, despite spread levels which seem fair or even slightly expensive, we remain cautiously optimistic about the asset class and both sub-segments of corporate credit and sovereign credit as there is embedded carry together with greater levels of dispersion within the asset classes.

We maintain a cautiously optimistic outlook on credit going forward. We acknowledge that corporate credit and sovereign credit present different risks and opportunities. In the corporate credit space, we see potential in carry, dispersion, and complexity premia, and we remain selective in our approach, focusing on specific stories and structured credit/CLOs. Additionally, we find attractive opportunities in certain geographies and emerging market external debt where fiscal accounts, governance, or debt sustainability have improved.

While we acknowledge that spread levels in both credit sub-assets may appear historically fair or slightly expensive, we believe that flexibility, agility, and the ability to identify compelling narratives on a bottom-up basis will be crucial for generating alpha in the coming months and years.

To comment specifically on our credit positioning within our Global Bond strategy, as of beginning of July we have around 40% of net exposure to credit of which: 28% in corporate credit² and financials while around 27% of our portfolios is long on external EM Debt and 15% of protection on the Itraxx Xover (which we steadily built during the year). In the short term, we have adopted a tactical risk management approach in using derivative instruments such as Credit Default Swaps or option strategies on credit indices to effectively protect portfolios against political and geopolitical risks.

It is important to position these views within the context of Global Bond philosophy and overall portfolio objective. A strategy where we aim to deliver improved returns versus fixed income markets coupled with a contained volatility (c.5%). For the case of completeness, the credit position complements the positions we have in the other 2 allocation buckets of the Global Bond strategy – Duration and FX.

Eni (hybrid corporate bond):

Similarly to financials, the energy sector presents numerous opportunities due to a significant disparity between the substantial financing needs of issuers and the sometimes-limited supply of capital, as strict responsible investment policies progressively impose more restrictions. From our perspective, we firmly believe in the indispensable role of energy sector players and continue to invest in companies that adopt best practices in this domain, such as Eni, a leading global energy company, boasting a diversified portfolio across oil, gas, and renewable energy and a stable cash flow generation.

Investing in ENI hybrid corporate bonds presents a compelling opportunity for investors. For example, the ENI hybrids callable in 2029 offer a yield of c.4.9%, which is significantly higher than the average yield for BBB rated corporate bonds. With a leverage ratio (Net Debt/EBITDA) standing at a very low 0.2x, and a free cash flow generation of €6 billion annually, ENI demonstrates solid financial performance and strong liquidity. The company’s strategic investments in renewable energy align with global sustainability trends and the European Union's regulatory support for clean energy initiatives.

We continue to like Romania, which with its BBB- credit rating, stands out among its regional peers due to its robust economic growth and significant inflows of EU and foreign direct investment, which help finance its relatively large fiscal and current account deficits. The country's GDP per capita, governance, and human development indicators surpass those of its peers in the BBB category, highlighting its strong fundamentals.

This is evident in the higher yields offered by Romanian government bonds (external debt) compared to Italian bonds of the same maturity. Furthermore, Romania's debt-to-GDP ratio in 2023 is lower than that of Italy, indicating a more favorable fiscal position (48.8% for Romania versus 137.3% for Italy in the same year). Additionally, Romania's substantial reserves of gas and wheat have provided a buffer against external shocks, such as those experienced in 2022, particularly from Russia. These factors contribute to Romania's resilience and attractiveness as an investment destination.