Confidence that the Federal Reserve can manage the tapering of asset purchases, with little market disruption, should make investors more comfortable taking on duration risk. The stability and yield pick-up provided by US investment grade credit look like a better way to position versus government bonds. Investor positioning and preferences, better long-term performance and lower volatility also suggests a focus on ESG.
Jackson Hole Sends Positive Message – What Comes Next for Fixed Income Markets?
The US Federal Reserve’s Jackson Hole Economic Symposium marked the big event of the summer, an opportunity for the Fed to set the direction of monetary policy into 2022. The fairly dovish message was what markets wanted to hear. And for bond investors, the combination of the view that both growth and inflation have peaked and that the Fed will carefully manage the wind-down of its policy stimulus, thus avoiding a “Taper Tantrum,” may see the appetite for duration risk increase.
That said, the bond market is known for posting positive performances over the summer only for there to be a change of direction in September.1 Indeed, one investment theme in our latest Bond Compass highlights this reversal as a risk factor for several fixed income strategies, most notably government bonds. The more negative performance from fixed income is often related to government supply, with the end to the holiday season seeing governments pushing to achieve their funding targets by year-end. From this perspective, we should observe a lower impact on corporate bonds for three reasons:
• While there will be a reopening of the primary issuance pipeline for corporates, the buoyant economic conditions, low interest rates and strong investor appetite for corporate paper during the early part of 2021 points to many companies having gotten well ahead of their funding needs for the year. Therefore, issuance pressures in the credit space could remain more muted.
• Tapering of asset purchases will not directly affect US credit as the Fed is no longer buying (it is actually selling down its credit holdings). Reduced buying will create more of a flow restriction on government bonds and MBS. On this front European credit may be more vulnerable to the ECB scaling back its purchases.
• US growth could be at or close to the peak but it should remain strong for the foreseeable future, with the Bloomberg consensus for GDP to rise 4.3% in 2022.2 This should provide a solid backdrop for corporate profits.
The economics may be supportive of spreads remaining tight but, for those concerned that there could still be some sort of a taper correction, focusing on investment grade paper can help to limit the risks of a blow-out in spreads. Even in the full-blown Taper Tantrum of 2013, US investment grade paper moved around 25bp wider versus US Treasuries, against a move of over 100bp for high yield.3
Get with the Flow: Investors Focus on ESG
US investment grade credit offers a yield-to-worst of just under 2%, which represents a pick-up versus US Treasuries of around 85bp4. In addition to the appeal of carry, the flow data in the Q3 Bond Compass suggested that investors were underweight US investment grade credit coming into the quarter, hinting that the period into the end of the year could see some rebuilding of positions. This trend already looks like it could be underway, with US investment grade corporate ETFs showing significant inflows in August 2021 (see chart).
US Investment Grade Corporate Bond ETFs: AUM and Flows, Monthly Evolution (in USD mn)
There is plenty of evidence to suggest that these flows will move toward ESG-compliant assets, not least from the survey of fixed income investors conducted by State Street Global Advisors in partnership with Longitude Research, a Financial Times company. The results are outlined in the publication Fixed Income: Preparing for the Big Shift, where the preference to reorient toward ESG fixed income assets is clear. Some 61% of respondents said that they are prioritising integration of ESG factors within their fixed income portfolios over the next three years. Investment grade corporate bonds were seen as a key segment for this integration, with 39% of investors suggesting this is a priority, only topped by high yield.
The investor survey also suggests that the most frequently integrated approach is currently best-in-class (49%), which fits well with the State Street Global Advisors approach of using an index that first screens for the usual ESG flags5 before optimising the index to maximise the R-Factor®, the State Street ESG score, at the same time as pushing the characteristics of the ESG index toward those of the parent index. In this way, those investors returning to US investment grade credit can keep their portfolio characteristics close to the benchmark while at the same time improving their ESG profile.
A part of this move to ESG is being driven by the direction of regulatory drift but there is also a growing acceptance that a best-in-class approach can deliver higher returns and lower volatility over the longer term. This is a theme we investigated in US Investment Grade Credit: Stability Through ESG and demonstrated the stabilising effect of ESG assets even during the market disruptions of March 2020 driven by the pandemic.
For Europe-based investors concerned that the USD may slide, which is entirely possible if the Federal Reserve manages the tapering of purchases without scaring the market, then hedging out currency risk is also something to consider.
How to play these themes
Investors looking to access the themes described above can do so with SPDR ETFs. To learn more about these funds, and to view performance histories, please click on the links below:
1 Average returns for the Bloomberg US Treasury Index have been positive over the past five years for June, July and August, but negative in September. See the Q3 2021 SPDR Bond Compass for details. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown.
2 This forecast is based on certain analyses and assumptions. There is no guarantee that the forecast will be met.
3 Based on the moves in the option-adjusted spreads of the Bloomberg US Corporate Bond Index and the Bloomberg US Corporate High Yield Bond Index. Source: Bloomberg Finance L.P.
4 Yield and spread for the Bloomberg SASB US Corporate ESG ex Controversies index, as of 31 August 2021, Source: Bloomberg Finance L.P.
5ESG Flags: Extreme Event Controversies, Controversial Weapons, UNGC Violations, Civilian Firearms, Thermal Coal Extraction and Tobacco producers
Information Classification: General Access.
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For Investors in Austria: The offering of SPDR ETFs by the Company has been notified to the Financial Markets Authority (FMA) in accordance with section 139 of the Austrian Investment Funds Act. Prospective investors may obtain the current sales Prospectus, the articles of incorporation, the KIID as well as the latest annual and semi-annual report free of charge from State Street Global Advisors Europe Limited, Branch in Germany, Brienner Strasse 59, D-80333 Munich. T: +49 (0)89-55878-400.F: +49 (0)89-55878-440.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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