While US Treasuries may well recover in the months ahead, we see greater potential for a rebound in US investment grade credit. Moreover, accessing this area of the fixed income market through a best-in-class ESG approach may afford investors a degree of protection if we see further market disruption.
After a Rough Q1, Potential Rebound Ahead
Fixed income investors endured a harsh first quarter with 10-year US Treasury yields pushing over 80bp higher. The move was so aggressive that it has affected most other fixed income assets. The question for investors now is whether we get a re-run of 2021, when Treasury yields declined over the next 4 months after the first quarter, or whether the market will sell off further. The 2015-2018 US Federal Reserve (Fed) tightening cycle saw yields peak just before the final policy tightening, suggesting yields have further to rise. However, in this case the track higher in yields was punctuated by several strong counter-trend rallies.
The aggressive nature of the sell-off has pushed the implied 1-year Treasury rate in 1 year’s time up close to 3%, which is well above the median for the Fed’s dot plot of where the governors expect central bank rates to rise (2.5%). With the market having got so far ahead of the Fed there could well be a consolidation or, potentially, a rebound in pricing as we get into Q2. However, rather than focus on Treasuries, the potential for a rebound looks greater for US investment grade credit, in our opinion. We see 4 important considerations.
Scale of the sell-off. The Q1 sell-off was greater for credit, with the Bloomberg US Corporate Index returning -7.79% to 30 March 2022 against -5.64% for the Bloomberg US Treasury Index.1 The magnitude of the decline was partly because the duration of the corporate index is more than 1 1/3 years longer than the Treasury index but, in the event of a rebound, this should play in favour of credit.
Spread widening. The option-adjusted spreads to Treasuries widened by over 50bp before coming back lower. While spreads have tightened they remain wider than the levels seen for the duration of 2021. Indeed, the spread can be regarded as a cushion and could continue to narrow if the Treasury market remains under pressure from strong economic data. Alternatively, softening US activity data may see spreads re-widen but this could be accompanied by a decline in underlying Treasury yields as the market prices out Fed policy tightening.
Yield consideration. The spread noted above also provides investors with some additional yield with the yield to worst on the Bloomberg US Corporate Index now more than 3.5% against 2.4% for the Bloomberg US Treasury Index.
Favourable environment. There are few signs of financial distress in the corporate sector. Growth remains firm and the favourable financing conditions of 2021 have allowed companies to strengthen their balance sheets. While the upgrades versus downgrades ratio has fallen below 1 for North American investment grade corporates rated by Moody’s, for S&P it has reached more than 3 for the first time since Q4 2018.
US Investment Grade Credit Yields are above 3.5% and Spreads Have Started to Come Back in
The rebound in energy prices coupled with renewed interest in defence companies has disadvantaged many ESG strategies during the early part of 2022. However, the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index has managed a 15bp relative outperformance versus its parent index over the course of Q1.2 It has also substantially outperformed other US investment grade strategies, such as the iBoxx USD Liquid Investment Grade Index, which was close to -8.5% on the quarter versus -7.7% for the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index.
While some of the screens for the ESG index may have weighed a little on performance during Q1, an attribution versus the parent Bloomberg US Corporate Total Return Index suggests a strong contribution to outperformance came from security selection. Technology, communications and consumer non-cyclicals each contributed around 5bp of outperformance to the ESG index.
The difference in performance between the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index and the iBoxx USD Liquid Investment Grade Index was more about duration, with an attribution suggesting this accounted for 74bp of the outperformance. Nevertheless, security selection still contributed 18bp of outperformance with the technology and communications sectors again key drivers of index performance.
In other words, while ESG may be encountering some challenging times, the focus on best-in-class issuers, which the optimisation process for the Bloomberg SASB Corporate ESG indices provides, can still play a role in reducing the degree to which prices fall when markets undergo a meaningful correction.
With EURUSD not that far from its 2020 lows, for those Europe-based investors concerned with the risks of a decline in the USD, a EUR-hedged version of the SPDR Bloomberg SASB U.S. Corporate ESG UCITS ETF is also available.
How to Play this Theme
Investors looking to access the investment grade corporate ESG theme can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the links below to visit their fund pages.
1Source: Bloomberg Finance L.P., as of 30 March 2022.
2Source: Bloomberg Finance L.P., as of 30 March 2022. The Bloomberg SASB US Corporate ESG Ex Controversies Select Index versus Bloomberg US Corporate Index.
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