Unfixing income: How we have started positioning for tighter market conditions

Our approach to managing income strategies is based on active management, supported by fundamental economic and credit research. Investment risk profiles evolve according to market conditions and our judgement on the balance of risk and reward. The ability to be flexible is key.

The current scenario is one in which credit markets are getting tighter. But we believe that looking beyond the headline measures of spread and yield for the overall market, could reveal areas of opportunity. The same can be said for stock markets.

Here, we share some examples of new positions we’ve taken up recently, given market performance. None of these ideas below will make or break our strategies – they’re all small positions amongst the hundreds we take. But they do provide a bit of insight as to why we’re willing to take some risk.

Spotlight: our Egypt position

Many of our portfolios invest in emerging markets (EM) and in our view, there are usually lots of opportunities in EM.

One such example is Egypt. Egypt is a ‘B’ rated issuer, and its big challenge is its persistent current account deficit. It’s an oil importer but it doesn’t have a big export base beyond tourism, so the country needs a permanent supply of US dollars (USD) to balance the books. 

Unfortunately, large capital inflows are hard to come by when your exchange rate is overvalued (there is a big gap between Egypt’s official rate and the unofficial rate). The country is currently in an International Monetary Fund (IMF) programme and the IMF made currency devaluation a pre-requisite to further money.

Egypt took the medicine and devalued its currency (Egyptian pounds - EGP) from 30 to 50 to the dollar. This inevitably sent inflation rocketing higher (currently 35%) so that will need to fall quickly.  We felt that at that level, the EGP was undervalued. At the same time, the United Arab Emirates (UAE) announced a $40bn¹ investment into the country, which when combined with the IMF money has put the EGP on a strengthening trend.

We recently bought some of Egypt’s long dated USD bonds. The coupon is reasonable, at 7.5% but we paid 60 for them. This gave a yield of more than 10%² and they’ve rallied quite a bit since. This is an example of the benefits of our agile management approach. 

But on the flip side, we also bought local currency T-Bills which mature this year. At the time of purchase, they offered a huge yield of 30%³. The key risk for these bonds is foreign exchange (FX). If Egyptian inflation stays very high and the Egyptian pound starts to weaken then we’ll likely give back a fair amount of those gains. But if inflation does fall back and the currency stays relatively stable, it’ll be a great trade.

AXA’s newly issued ‘RT1s’

Our second example comes from an issuer much closer to home. Perhaps not as exciting as Egypt but has produced good income - AXA. It’s one of Europe’s largest multi-line insurers, offering life and non-life products as well as broader financial services. It has a €77bn market cap⁴ and an S&P senior rating of A-. It has had strong credit, but its senior bonds haven’t given much spread.

Recently though, AXA issued a Restricted Tier 1 (RT1) bond, which we bought at launch because of its  coupon rate of 6.375%. An RT1 is like the insurance equivalent of an Additional Tier 1 (AT1). Sitting just above equity in the capital structure, (below the older generation junior securities), they are perpetual bonds with calls. Coupons can be suspended and capital impaired.

With banks and AT1s, the yardstick is a bank’s capital ratio. With insurers, it’s their ‘solvency ratio’.  RT1 bonds could become impaired if the solvency ratio falls to 100%. Insurers typically target a solvency ratio of 140-180%. AXA’s ratio today is 227%⁵.

The RT1 universe is still very small and there is no real market convention as to whether these bonds will be called. In any case, the first call date for this security is not until 2033. The only reason AXA needed to issue these bonds in the first place is because the older style junior bonds we often mention are losing their capital status (they will simply become senior financing) in 2025.

Equities spotlight: Broadcom case study

Equities have had an important role to play in the performance of our income portfolios too. One such stock, which we hold, is Broadcom. It’s a Californian-based tech company involved in AI The company estimates that 99.9% of all internet data traffic passes through its technology.

Broadcom makes components for smartphones, set-top boxes, wi-fi routers, DSL gateways to the internet, technology used in cars for vehicle connectivity, cameras and sensors. It has a business geared to providing infrastructure for data centres and it is involved in cyber security as well. One of its specialisms is chips for networking. It generated $200m in revenue from these in 2022⁶ .

There are risks, of course. The semiconductor industry is highly sensitive to the state of the economy while rapid technological change leaves the business at risk of being overtaken by disruptors. But in the past, Broadcom demonstrated an ability to invest well in research and development and make smart acquisitions. It started expanding its AI capacity and building new data centres specifically equipped to support next-gen AI hardware.

With a wide array of revenue flows in critical sectors, as well as solid cash flow, its shares were up 120%⁷ over the past 12 months.