KEY TAKEOUTS

• Amid the ongoing uncertainty characterising the current investment backdrop, the high-yield sovereign debt sub-asset class offers the safety of fixed income coupled with the growth potential of equities.
• This asset class offers the unique combination of debt issued by sovereign entities, higher interest rates reflected by lower credit quality and denomination in hard currencies.
• The category has a quasi-equity nature, which stems from its higher risk profile relative to investment-grade bonds and typically offers higher returns compared to investment-grade bonds.
• Unlike lower-yielding bonds, the higher coupons of high-yield bonds provide a steady income stream, which is especially valuable in volatile market conditions and contributes to the total return over time.
• Hard currency sovereign bonds are denominated in stable currencies like the U.S. Dollar (USD) or the Euro (EUR), offering a clear advantage over local currency sovereign bonds.
• The Old Mutual African Flexible Income fund's focus on African high-yield sovereign bonds offers a unique approach within the broader high-yield market. This regional focus on African ex-SA securities allows for deeper insights into the specific factors influencing credit risk.

Investors globally have had a torrid time of it over the past three years, with a global pandemic and rising inflation and interest rates making the search for yield an elusive exercise. We now find ourselves in an increasingly uncertain investment environment, both locally and globally, with investors continuously having to adjust their expectations for the inflation trajectory and interest rate outlook. This leaves local investors with the conundrum of balancing risk and reward as they search for investment opportunities that can both weather a storm and deliver a return.

The high-yield sovereign debt category is often overlooked, given the risk premium attached to the asset class. However, investors seeking a balance between the safety of fixed income and the growth potential of equities would do well to consider high-yield hard currency sovereign debt, particularly against the current investment backdrop. This unique sub-asset class offers an interesting combination of features, the first of which is that it is debt issued by sovereign entities, meaning it is backed by national governments as opposed to corporate issuers. Secondly, "high yield" refers to the higher interest rates these bonds offer, which reflects their lower credit quality (although this is not the only factor). Finally, unlike debt issued in a country's local currency, these bonds are denominated in hard currencies, typically the US Dollar (USD) or the Euro (EUR).

Sovereign debt: Backed by national governments

Sovereign debt refers to the money borrowed by a country's government through the issuance of bonds. Unlike corporate debt, which is issued by companies to fund operations and expand business, sovereign debt finances governmental activities and public projects. A key distinction between sovereign and corporate debt is the risk of bankruptcy. While companies can go bankrupt if they fail to meet their financial obligations, countries do not go bankrupt in the traditional sense. Instead, they may default on their debt, which significantly impacts their creditworthiness and ability to raise funds in the future.

When a country defaults, its bonds typically devalue but rarely become worthless, often bottoming out at around 30 to 40 cents on the dollar, which reflects the residual recovery value investors anticipate. Countries strive to avoid default because it severely restricts their future market access and increases borrowing costs. Thus, governments exhaust multiple avenues, such as negotiating with creditors, restructuring debt terms, or seeking international financial aid, before opting to default or restructure their debt. This proactive approach contrasts with corporations that might consider bankruptcy restructuring (such as Chapter 11 in the U.S.) as a viable option to reduce and reorganize debt under court supervision, often leading to a more abrupt impact on creditors.

High Yield: Balancing risk and return

A distinctive feature of high-yield hard currency sovereign debt is its quasi-equity nature, which sets it apart from both traditional fixed income securities and equities. This characteristic stems from its higher risk profile relative to investment-grade bonds, yet with a risk level that remains below that of equities. This intermediate risk positioning makes high-yield sovereign debt a viable option for investors looking to balance their portfolios between the safety of fixed income and the growth potential of stocks.

An examination of historical return series reveals that high-yield hard currency sovereign debt typically offers higher returns compared to investment-grade bonds. This potential for elevated returns, however, comes with increased volatility, underscoring the quasi-equity nature of these instruments.

When considering the risk landscape of fixed income investments, two primary types emerge: credit risk and interest rate risk. High-yield bonds, with their lower credit quality, naturally exhibit a higher credit risk, indicating a greater chance of default compared to their investment-grade counterparts. However, this increased credit risk is counterbalanced by a lower sensitivity to interest rate changes, thanks to the higher coupons that these bonds typically offer. This dynamic creates a unique risk-reward profile for high-yield sovereign debt.

One of the most appealing aspects of high-yield hard currency sovereign debt is what can be described as the "higher coupon engine." This refers to the significant role that higher coupon payments play in driving the investment's overall performance. Unlike lower-yielding bonds, where price appreciation might contribute more significantly to returns, the higher coupons of high-yield bonds provide a steady income stream. This income generation capability is especially valuable in various market conditions, acting as a buffer against volatility and contributing to the total return over time.

The chart below illustrates the coupon “engine” from the onset of Covid to date. High-yield bonds (proxied by the Africa bond index) have been supported by coupon return of almost 40% over the period, whereas investment-grade bonds have only had half that returns from its coupons. In addition, the coupon return from investment-grade bonds has not been enough to offset the impact of negative price returns from higher yields. As a result, over the period, investment grade bonds still show a negative overall return, compared with high-yield bonds that are now in positive territory.

Hard Currency: stability and liquidity

Hard currency sovereign bonds are denominated in stable currencies like the U.S. Dollar (USD) or the Euro (EUR), offering a clear advantage over local currency sovereign bonds. Hard currency provides stability, reducing the risk of currency volatility that can affect the value of bonds. This characteristic is crucial for funds seeking to generate consistent returns in USD or EUR without the risk of currency depreciation.

Additionally, hard currency bonds mitigate risks associated with currency convertibility and repatriation. Since these bonds are traded on international markets, investors are not exposed to the risk of having their funds trapped in countries with restrictive currency controls. This stability and liquidity make hard currency bonds an attractive choice for funds and investors seeking flexibility in their portfolios.

Regional focus: African high-yield sovereign bonds

Old Mutual Investment Group launched its African Frontier Flexible Income Fund almost two years ago. This fund leverages the learning and capability developed from the Group’s African Frontiers equity fund, one of the longest running (specialist) African funds in the market. The Old Mutual African Frontiers Fund is rated 5 stars by Morningstar/Lipper.

The fund's focus on African high-yield sovereign bonds offers a unique approach within the broader high-yield market. This regional focus on African ex-SA securities allows for deeper insights into the specific factors influencing credit risk, such as "willingness to pay" and the approach to restructuring or default. The fund's extensive experience in Africa, established through relationships with industry participants and regular meetings with policymakers and regulators, provides valuable insights into these qualitative aspects of credit analysis.

Understanding the regional context, including the political landscape, economic trends, and government policies, is critical for assessing risk and reward in African high-yield bonds. Focusing on Africa provides a competitive edge for our fund, allowing it to navigate unique challenges and uncover opportunities within the African high-yield bond market.

Finding stability, security and elevated returns

High-yield hard currency sovereign debt offers an attractive balance of risk and return, combining the stability of sovereign backing, the security of hard currency, and the elevated returns of high-yield bonds. Combined with the regional focus on African high-yield sovereign bonds, which leverages specialised knowledge and relationships, this sub-asset class offers a unique opportunity set for investors, if accompanied by an appropriate level of understanding of the characteristics and risks associated with it. Set against the current turbulent backdrop of uncertainty facing global markets, investors with exposure to high yield can make informed decisions to navigate this environment and align with their investment goals.