06 Sep 2019
The returns from this trade were designed to be generated by three components: the yield, a capital return should yields fall and – as we held the position in local currency – the return from a move in the Polish zloty versus the euro. However, our assumption was that the currency pairing would remain relatively flat. Since inception, the trade generated a positive yield, as well as a positive capital return as yields fell during that time. The only small negative drag on returns has come from the Polish zloty marginally depreciating versus the euro (see Figure 1).
Source: Bloomberg as at 21 August 2019.
However, we reviewed this trade following the recent 75-basis point fall in yield experienced by 10-year Polish government bonds over a period of roughly six weeks. And after completing our research, we made the decision to remove the trade from our portfolio.
Polish bond yields are not yet at their lows, so some may question why we did what we did. In our view, Poland has seen a change in the underlying drivers of inflation, which has fundamentally changed the investment thesis we had for this particular trade.
There is one essential element we look for in emerging market bonds: after accounting for the credit premium, we want the real yield of the bond (nominal bond yield less inflation) to be positive. Accounting for credit premium means we are allowing for the perceived credit worthiness of a country in our thought process, because when we buy government debt, we are essentially lending money to that government.
Recently, Polish inflation has moved up, which has resulted in real rates moving into negative territory. Granted, this is only an issue if you believe that inflation will persist. We have seen a similar situation in the past (such as Q4 2016/Q1 2017), but it’s different this time: core CPI is within the target band of the Central Bank of Poland, and importantly, all components of inflation are now in positive territory and on what appears to be an upward trend. This suggests that higher core CPI could persist going forward and increases the risk that the next move by the Polish central bank could be an interest rate hike.
Source: Eurostat, Haver at 30 June 2019.
The Polish government is also embarking on another fiscal push through many different policies – one example being the initiative to pay families 500 zloty per month per child, which previously was only done for every second child and above. This has started to feed through to core inflation. These fiscal changes, alongside extremely solid GDP growth rates of 4.7%, an improved current account balance compared to history, 6-8% wage increases and improved labour productivity all mean that the Polish economy is bucking the trend of the rest of the world and is showing domestic strength in contrast to other parts of Europe (see Figure 5).
Source: Bloomberg as at 30 June 2019.
Relative to other Eurozone bond markets, Polish bond yields did look very attractive. However, the yield spread relative to Bunds has narrowed recently. In addition, the Polish yield curve has flattened, which means there is less reward for holding longer-term securities, whilst the absolute level of yield has fallen. All of these factors, combined with the growth and inflation drivers as previously discussed, has led to us removing this trade from the portfolio after it had positively contributed to fund performance.
Given the solid macro dynamics in Poland, the roughly 2% positive carry and the increasing likelihood that the next move from the Central Bank could be an interest rate hike, pushing yield differentials to Europe wider, we have decided to keep the currency exposure to Poland. The Polish zloty has been stable for quite some time against the euro around the 4.20 mark. We favour the Polish currency versus the euro, but even if the relationship between the two currencies remains relatively stable, this would result in a positive carry for the portfolio.
We hope the above gives some insight into the way we think about our ideas, the pillars on which they are built and shows how our rigorous process is key to our decision making in both the review and removal of ideas.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.
The Invesco Global Targeted Returns strategy uses derivatives (complex instruments) for investment purposes, which may result in a portfolio being significantly leveraged and may result in large fluctuations in value. The strategy may hold debt instruments which are of lower credit quality which may result in large fluctuations in value. Changes in interest rates will result in fluctuations in value.
Important information
All data is as at 31/07/2019 and sourced from Invesco unless otherwise stated.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
This article is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.