US ESG IG Credit: Still a Key Component of Fixed Income Portfolios
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.