US investment grade credit suffered in Q1 2021 on the back of rising Treasury yields. Outright yields are now higher and spreads to government bonds a little wider, which should appeal to European investors in particular. Yield spreads to Euro credit are at multi-year highs on a currency-hedged basis. So an allocation to US credit makes sense but, to capitalise on where the flows are going, focus on ESG funds.
Investment grade (IG) credit was the darling of investors in 2020. Dramatically wider spreads to government bonds, following the March sell-off, coupled with a central bank backstop made IG credit an easy investment choice. However, the positive feelings toward the sector had largely played out by the end of the year. Rising US Treasury yields, the end to the Federal Reserve’s buying program and little room for further spread compression meant that Q1 2021 was a rough one for IG bonds with negative returns and net investor selling of the sector as US Treasury yields surged. Nevertheless, with every price reset comes an opportunity to reassess value and, in the case of US IG credit, we see reasons to be positive again.
There are some risks to US fixed income assets if inflation continues to exceed expectations but the spread compression between both US Treasuries and German Bunds hints that there has been a move by the investors to reduce EUR exposure and reach for higher-yielding US assets.
Source: Bloomberg Finance L.P., as of 16 April 2021.
Last week’s announcements on cutting carbon emissions by both the UK and US governments as they prepare for COP 26 in November are going to intensify the focus on climate and ESG themes. So for investors thinking about venturing into US IG Credit, it makes sense to consider an ESG exposure. As outlined in the Bond Compass, the notable trend in US credit flows for European investors over the last 12 months has been into ESG-based investment strategies.
A key issue for investors who are covering underweight positions in credit is that of benchmark tracking as many ESG strategies bear only a loose similarity to the wider bond exposures. For instance, the allocation to banking bonds in the Bloomberg Barclays US Corporate Index is 20.9% but the average for a basket of seven Bloomberg Barclays MSCI ESG indices2 is over 25%. The mis-alignment of sector weightings can cause tracking error.
The Bloomberg SASB US Corporate ESG Ex-Controversies Select Index screens out companies that derive sales from tobacco, weapons and thermal coal and also excludes those involved in controversies or that have violated the United Nations Global Compact. The index is then optimised to both maximise its ESG score and push its characteristics toward those of the parent index. This means sector weights are more closely aligned to the Bloomberg Barclays US Corporate Index, therefore limiting tracking difference. This provides a neat solution for investors seeking to switch holdings into ESG-compliant funds but at the same time remain close to the benchmark.
European-Domiciled ETP Segment Flows (Top/Bottom 5, $mn)
European-Domiciled ETP Asset Category Flows ($mn)
Source: Bloomberg Finance L.P., for the period 15-22 April 2021. Flows are as of date indicated and should not be relied upon as current thereafter. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future
1The yield to worst on the Bloomberg Barclays US Corporate Index was 2.16% as of 23 April 2021, source Bloomberg Finance L.P.
2Basket is equally weighted and includes: Bloomberg Barclays MSCI US Corporate SRI; Bloomberg Barclays MSCI US Corporate Sustainable SRI; Bloomberg Barclays MSCI USD Liquid Investment Grade Corp Sustainable and SRI; Bloomberg Barclays MSCI USD Liquid Corporate ESG Weighted Index; Bloomberg Barclays MSCI US Corporate ESG Sustainability SRI; Bloomberg Barclays MSCI US Crp Sustainability SRI Sector/Crdt/Maturity Neutral Index; Bloomberg Barclays MSCI US Corporate SRI Carbon ESG-Weighted Index. All weights as of 31 March 2021.
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