While investment grade (IG) credit is not as defensive as Treasuries, it stands in a better position than non-IG paper if the pandemic has any more surprises to throw at us. Therefore, we expect IG credit will remain important for fixed income portfolios, and recent flow trends suggest investors are also keen to add an ESG overlay to their IG credit exposure.
Much like an ageing sports star relegated to the benches, investment grade (IG) credit, the darling of investors in 2020, seems to have been side-lined as market participants seek more risk-on trades. This makes sense from a timing perspective, given Q1 is the time to take risk and the economic environment also supports such an approach.
The US economy is holding up well: GDP for Q4 2020 was 4% (with the potential to be revised up) and the Composite ISM points to a re-opening of the US economy in January. Weak employment numbers have seen the newly in control Democrats push for a substantial spending package – a real economic kick-starter. So the economic backdrop certainly appears to favour assets such as high yield bonds and convertibles, both of which we covered as investment themes in the Q1 Bond Compass.
That said, IG credit remains an essential component of any fixed income portfolio. The higher growth, higher inflation and higher spending environment is unambiguously bad for government bonds and has steepened the US Treasury curve, despite ongoing Fed purchases. It is far less damaging to IG credit where stronger growth should help strengthen corporate balance sheets.
A key question is the degree to which spread compression can occur to offset any further rises in US Treasury yields. Figure 1 shows option-adjusted spreads (OAS)1 plotted against the 10-year US Treasury yield each year since 2010. The chart illustrates that, while spreads are tight, they have been tighter. This has typically occurred at higher yield levels on the 10-year and it looks likely that, as growth gains traction and additional shutdowns become less likely, spreads will edge tighter, squeezed by higher Treasury yields and improvements in credit quality.
This additional yield pick-up versus US Treasuries is also an important consideration. The recent sell-off in US Treasuries has pushed yields on the Bloomberg Barclays Corporate Bond Index up close to 1.90%. This is above the yield on the Bloomberg Barclays US Treasury: Long Index, which focuses on the 10+ Year segment of the Treasury curve. This long-dated index has a duration of close to 19 years, which makes it more than twice as sensitive to rises in underlying yields.
Additional yield also provides IG investors with protection. The Bloomberg Barclays All Treasury Index has a yield to worst of 67bp and a duration of close to 6.9 years, which implies that a modest 10bp rise in yields would neutralise returns from the coupon. For a US IG corporate strategy, the yield rise required is more than double that2.
Finally, the Fed may have halted its purchases of credit but it is assumed that it would reopen the SMCCF3 if market liquidity conditions deteriorate again. So while IG credit is not as defensive as Treasuries, it stands in a better position than non-investment grade paper if the pandemic has any more surprises to throw at us.
ESG: A Clear Shift in Investor Behaviour
While we expect IG strategies to remain a key component of fixed income portfolios, there are shifts in the type of strategies that investors can deploy. For IG corporates, the transition has been towards ESG. Figure 2 shows net flows over the past 12 months for EMEA-domiciled fixed income ETFs, split not only by type of fund but also by whether they have an ESG flag4.
There has been a clear rotation out of conventional strategies and into ESG in the European IG credit space. The shift is less evident in the USD market but is likely to gather pace as the Biden administration starts to drive the ESG agenda. Stricter climate regulations and demands for ESG disclosures should prove a wake-up call to those who still doubt that ESG will play an increasing role in investment strategies. For five key themes that we think the Biden administration will focus on, see ESG and the Biden Presidency.
The Bloomberg SASB US Corporate ex Controversies Select Index facilitates the rotation out of conventional strategies and into ESG. The index is optimised with the twin objectives of allocating to best-in-class ESG issuers while at the same time producing an index that has similar characteristics to its parent, the Bloomberg Barclays US Corporate index. The best-in-class approach to bond selection helped this ESG index to outperform its parent index by more than 80bp in 2020. Reduced exposure to sectors such as transport and energy has also helped to reduce volatility.
How to play this theme:
Investors looking to access US corporate bonds with a focus on ESG can do so through a SPDR ETF. To learn more about the ETF, and to view full performance history, please follow the link below:
SPDR Bloomberg SASB U.S. Corporate ESG UCITS ETF
Sources: Bloomberg Finance L.P., for the period 4 – 11 February 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.
1Option Adjusted Spreads for the Bloomberg Barclays US Corporate Bond Index
2The Bloomberg Barclays US Corporate Bond Index has a yield-to-worst of 1.86% and a duration of close to 8.7 years meaning a rise of over 20bp would be required for capital losses on the bond to offset the coupon. Source Bloomberg Finance L.P. All calculations as at 10 February 2021.
3Secondary Market Corporate Credit Facility
4ESG flags are Bloomberg ones
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