Euro Investment Grade Credit: Catching the Turn while Trimming Bank Exposure
As the ECB and Fed weigh their next moves, investors are left to consider how best to position for an uncertain outlook. While we may be nearing peak rates from the ECB, there is still the possibility of a surprise. For investors who are waiting to see what comes next, investment grade credit offers one way to introduce some defensiveness into portfolios.
Both the Fed and ECB delivered the expected 25bp rate rises at their latest meetings. The bigger question for markets was always going to be what happens next. For the Fed, unless the activity and inflation data stay stubbornly high, rates would appear to be on hold, with downside risks if growth weakens. The ECB looks like it has more tightening to deliver, but the market only sees them delivering a further 50bp of rate rises.
While considerably less certain, this backdrop does hint that the peak to ECB rates may also be close and, as we illustrated in the Q2 Bond Compass, now is an interesting time to consider allocating into investment grade (IG) credit. IG grade credit could offer defensive facets in several of the potential scenarios that may develop:
- Central bank tightening cycle persists: It is not difficult to see a world in which the Fed and ECB need to raise rates by more than is priced by the market. With curves pricing rates falling in 2023 and into 2024, this scenario would be damaging for fixed income. Credit exposures should get some protection from the fact that presumably growth would have to remain relatively strong to justify persisting with the tightening cycle and this should result in credit spreads tightening.
- The pause: The Fed has hinted at a pause in rates rather than cuts. If the pause persists for any length of time, then IG offers a pick-up in yield versus underlying government exposures. A refusal to cut rates likely would be because growth remains better than many expect and this could see credit spreads tighten.
- Cuts delivered: Entering the easing phase of the cycle should support fixed income and, as long as growth does not collapse, there is little reason why the effect of spread widening should offset the impact of decline in the underlying government yield curve. As shown in the Bond Compass, US credit returns accelerated once the fed funds rate started to fall in 2019. The key risk would be a sharp slowdown, which would see spreads widen; however, in such an event, IG exposures should be less at risk than high yield.
Where the US Goes, Others Follow
The case for Euro IG credit exposures at first seems more nuanced than for the US. The ECB still has at least 50bp of further tightening to deliver and it is now running off its holdings of corporate bonds. However, spreads on the Bloomberg Euro Aggregate Corporate Index, at 165bp, are around 45bp wide to their 10-year average, suggesting a degree of economic slowing is already priced in1. Ratings upgrade momentum is strong, with the upgrades/downgrades ratio for Western Europe spiking to 5 for Moody’s and 6.75 for S&P at the start of Q2 (from levels of around 1.5 in Q1)2.
Additionally, history tells us that EUR corporate returns are heavily influenced by US market moves. The correlation between the changes in returns of the Bloomberg Euro Aggregate Corporate Index and the Bloomberg US Corporate index is 76.5% based on weekly data for the past 5 years3. Importantly, the EUR corporate exposure posted gains during the period when the Fed was cutting rates in 2019 even though the ECB was not.
Trimming Bank Exposure
While US corporate trends often affect the European markets, one that investors hope will not jump the Atlantic is the current uncertainty in the banking system. The banking sector represents close to 32% of the Bloomberg Euro Aggregate Corporate Index and has been its worst performing sector year to date. High weightings to banks is especially an issue for those investors focused on ESG strategies, where exposure can be above 50%.
Looking at the largest 4 Euro corporate ESG UCITS ETFs by AUM, the indices that these ETFs follow have an average exposure of 38% in banks4. This is driven by allocating index weights based on a process of exclusions for controversial business practices and based on an ESG rating with a rather agnostic approach to sector weights. In contrast, the Bloomberg SASB Corporate Ex-Controversies Select indices attempt to maintain similar risk characteristics to the parent index. One of these index optimisation constraints is to align Bloomberg Class 2 Sector weights to within 200bp of the parent index.
Index Returns
For the Bloomberg SASB Euro Corporate Ex-Controversies Select Index, this results in a weight to banks of just over 21%, which is very low relative to most other ESG indices. This weighting has proved beneficial, with performance during the past 12 months actually less negative than the market-weighted index. Over a longer time period, the index methodology has also delivered favourable returns, with the Bloomberg SASB Euro Corporate Ex-Controversies Select Index delivering strong returns versus its peer group as investors endured fairly average levels of volatility.
5-Year Annualised Returns vs. Volatility
