Expectations suggest that the end of the Fed’s rate hiking cycle could be nearing. US investment grade credit has seen a material re-pricing and, looking at the previous hiking cycle (2016-2018), this exposure started to gain traction once markets believed the final rate hike had taken place. Is it now time to revisit investment grade credit?
Central banks continue to focus on inflation, with the ECB, Fed and BoE all opting to hike rates. As such, they have tried to put some space between the objectives of monetary policy (controlling inflation) and the task of managing issues in the banking system. However, tighter credit conditions as a result of the challenges in the banking sector do change the dynamic for the economy. So while the immediate crisis may have abated, central banks largely concede that tighter credit conditions point to the top to the monetary policy cycle being close at hand.
The issues in the banking sector have not been easy for asset markets to navigate. There are now real fears that the policy tightening that has already been delivered, coupled with tighter credit conditions, could tip growth into negative territory. On the back of this worry, there has been a risk-off switch to more defensive strategies, such as money market funds, but the point of maximum pressure seems to have passed with markets now more stable.
Although risks remain, US investment grade bonds have undergone a material re-pricing. Spreads to Treasuries blew out to the wides seen in October 2022, the point of peak bearishness in markets. Spreads have reversed some of that move but remain at 145bp for the Bloomberg US Corporate Index, well above the 115bp it hit in early February and 20bp wide to the 10-year average. This gives the index a yield to worst of close to 5.2%.
Credit spreads therefore offer some protection against a US economic slowdown. This spread to the underlying ‘risk-free rate’ is one component of returns, the other being what happens to underlying Treasury yields. This is typically dependent on the stage of the monetary policy cycle and, as already indicated, expectations are that the end of the Fed rate cycle is close.
While each cycle is different, Figure 1 shows the 2016-2018 Fed tightening cycle and how, during that cycle, returns from the Bloomberg US Corporate Index were fairly flat until late 2018. Positive returns from the index started to feed through in a more sustained manner once the market seemed sure that the final hike was in place. Gains stretched through into 2020, only undergoing a serious correction as markets priced in the big hit to GDP from COVID. A large part of those returns came from the rally in the underlying Treasury curve.
Figure 1: US Corporate Returns Gained Traction as the Last Fed Hike of the 2016-2018 Cycle Came
Higher sector weightings for financials are common within ESG strategies given the better ESG profile that the sector typically enjoys. If bank profitability is impaired, this threatens to be another factor that could weigh on ESG performance. Looking at four of the most widely used ESG indices, their average weight in banking bonds is just more than 30%, which is over 6% higher than the market-weighted index1. It is no surprise that only one of those four indices has outperformed the Bloomberg US Corporate Index year to date and that was mainly because of its longer duration2.
The Bloomberg SASB ESG Ex-Controversies Select indices take a different approach to sector allocations. Once issuers that derive significant revenue from certain practices, industries or product lines have been excluded from the parent index, the index is optimised. In addition to aiming to maximise the ESG score, the optimisation process targets risk characteristics for the new index and tries to align them with the parent index.
With respect to sector allocations, the objective is to target Bloomberg Class 2 sector weights that are within 200bp of the parent index. This results in a financials weight that is just 9bp from the parent weight and a banking sector weight that is only 76bp above that of the parent index. This could help to reduce any performance drag emanating from a high weighting in banks. Indeed, returns year to date have been 4bp higher for the Bloomberg SASB US Corporates ESG Ex-Controversies Select Index than for the market-weighted Bloomberg US Corporate Index3.
1 Four indices used: Bloomberg MSCI US Corporate SRI Total Return Index, Bloomberg MSCI US Corporate ESG Sustainability SRI Index, Bloomberg MSCI US Corporate Sustainable SRI Index, Bloomberg US Liquid Corporates Sustainable Total Return Index. In comparison with the Bloomberg US Corporate Index. Source: Bloomberg Finance L.P., weights as of 1 March 2023.
2 Returns year to date: Bloomberg MSCI US Corporate SRI Total Return Index 3.06%, Bloomberg MSCI US Corporate ESG Sustainability SRI Index 3.01%, Bloomberg MSCI US Corporate Sustainable SRI Index 3.01%, Bloomberg US Liquid Corporates Sustainable Total Return Index 3.72% versus Bloomberg US Corporate Index 3.11%. Source: Bloomberg Finance L.P. as of 22 March 2023. The Bloomberg US Liquid Corporates Sustainable Total Return Index has a duration of 7.38 versus 7.02 for the Bloomberg US Corporate Index. Source: Bloomberg Finance L.P. as of 01 March 2023.
3 Source: Bloomberg Finance L.P. as of 22 March 2023.
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