Markets are pricing in tighter central bank policy but, until there is some clarity on inflation, it will be hard to say rates have peaked. With European growth more vulnerable to high energy prices, we see an opportunity in short-maturity euro investment grade strategies to provide a buffer against rising rates. Investors could also consider an ESG approach to this exposure. ESG screening and index optimisation can enhance performance even during challenging periods, which we saw in Q1 2022.
Inflation is at historically high levels and many central banks appear to be behind the policy curve. Pressure to start normalising interest rates is acute – see our Q2 Bond Compass: Solutions for a New Rate Regime for further discussion of this topic. The European Central Bank (ECB) has yet to start the normalisation process and the markets have in mind that, like the US Federal Reserve (Fed) and Bank of England (BoE), the ECB will raise rates aggressively. The ESTR forwards price 75bp of rate rises by the end of 2022 and 130bp over the coming 12 months.1
While there seems to be an indisputable case for lifting policy rates out of negative territory, it may be more challenging for the ECB to embark on an aggressive policy tightening cycle for several reasons:
ECB Public Sector Purchase Programme Steps up a Gear
In short, the market now prices in a considerable amount of tightening and there are risks that the ECB does not validate this. A key disincentive to investing in the front end of the curve in the euro area has been the lack of running yield: despite the bond market sell-off, the two-year German government bond still only yields just over 10bp.
One way to enhance the running yield is to focus on investment grade credit. The yield to worst on the Bloomberg EUR Corporate 0-3 Year Index is above 95bp, its highest since mid-2014 if the 2020 Covid related spike is ignored. Spreads to government bonds have blown out to their widest since Q1 2013, again if the 2020 spike is looked through. This is despite the fact that the cessation of ECB purchases will be more damaging for government bonds than corporate bonds, given the relative amounts purchased, and suggests that a meaningful economic slowdown is already priced by markets. Signs of financial stress are limited so far, with the upgrades-to-downgrades ratio for Moody’s dropping to 0.56 in Q1 2022 but then rebounding to 1.67 for Q2 so far. For S&P, the ratio has remained well above 2 for both quarters.
For those thinking about returning to investment grade exposures, it may be time to consider ESG. In 2021, 13 out of the 14 UCITS credit ETFs launched had some sort of ESG screening.2 The rise of ESG was challenged early this year by the invasion of Ukraine, which drove outperformance for the typically non-ESG-compliant sectors of energy and defence. However, there are different approaches to ESG.
The State Street Global Advisors approach for fixed income ETFs is to create a series of indices, in conjunction with Bloomberg, that reflect the characteristics of the standard non-ESG benchmarks. This way, these exposures can be used for core holdings while at the same time enhancing the ESG rating of the portfolio. Screening then optimising the index, to both maximise the ESG score and to push the characteristics toward those of the parent index, has also helped performance. The Bloomberg SASB Euro Corporate 0-3 Year ESG Ex Controversies Select Index, the index behind our newly launched short-maturity ESG fund, has outperformed the Bloomberg EUR Corporate 0-3 Year Index by 14bp year to date3 despite the non-ESG-friendly backdrop.
To learn more about our range of fixed income ESG ETFs, we invite you to read our overview that provides an explanation of SASB methodology and how investors can use these exposures in the current environment.
1 Euro Short-Term Rate forwards. Source Bloomberg Finance L.P. as of 28 April 2022.
2 Source: Morningstar, as of 31 December 2021.
3 Source: Bloomberg Finance L.P., as of 27 April 2022.
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