Investment grade (IG) credit has enjoyed strong gains since the US election, with spreads to government bonds compressing to levels close to those seen before the pandemic. Indeed, spread narrowing has been so sharp that some see the move as over-done. After all, there is little certainty around how quickly the vaccine roll-outs can occur and people can return to work. What the post-pandemic world looks like is also unclear, with the long-term damage to the economy an unknown.
Perceptions that markets have priced in a lot of good news is not confined to IG. In fact, the asset class is in good company as many equity indices have hit fresh all-time highs and high yield credit spreads are also back at levels last seen in early 2020.
Conversely, for many who view their investment horizon through the lens of an economic rebound, it is easier to argue that government bonds, and not risk assets, look expensive. While US Treasury yields have edged a little higher, central bank buying is restraining the impetus for yields to rise to a meaningful degree. Some investors may retain a preference for safe assets past year-end but the drag of negative or, at best, low yields is a challenge for investors.
In addition, just because central banks remain committed buyers, there is no guarantee of perpetually low yields. Figure 1 below illustrates the inconsistent relationship between ECB government bond purchases and the 10-year bund yield. Yield spikes have occurred on numerous occasions despite a heavy program of buying. While the ECB’s additional EUR 500 billion of purchases and the extension to the program will be welcomed by the market, issuance in 2021 will remain high and will be added to by the EU’s pandemic recovery fund, which aims to raise EUR 750 billion.
Figure 1: ECB Government Bond Purchases vs. the 10-Year Bund
Source: Bloomberg Finance L.P., as of 4 December 2020.
So perhaps the ‘half-way house’ that IG credit represents is exactly what investors need in these uncertain times precisely because the asset class does not depend on the development of a single scenario.
So while IG credit returns are unlikely to rival those seen over the past six months, the asset class should act as a relatively stable asset that has a positive yield and, in our opinion, retains some upside return potential going into 2021.
The flows and holdings data in our Q4 Bond Compass suggest that investors were already overweight IG credit coming into the Q4. This may limit investors from adding holdings and means it may prove beneficial to focus on areas where we believe the inflows will persist: in ESG credit.
The focus on ESG has been significant in 2020, with an incredible 83% of flows into euro IG credit ETFs moving into ESG-screened funds, according to Morningstar data.2 We saw only 12% of flows for the equivalent US IG corporate funds and 19% for GBP, meaning there is room for these markets catch up. With 2021 likely to see a more pro ESG agenda from the White House, and with regulation becoming more widespread in Europe, we expect the trend towards ESG investing to remain in place.
An increasing flow of investment directed towards ESG-compliant assets could see these assets start to outperform their peer groups. This suggests a best-in-class approach (where funds focus on the issuers with the highest ESG scores) should be favoured, such as the one adopted for the Bloomberg SASB Corporate ESG Ex-Controversies Select indices. These indices are optimised so that their characteristics are pushed back towards their parent indices, and thus they can be used as a building block for a credit portfolio.
SPDR offers a range of ETFs that allow investors to access exposure to the themes described above. To learn more about these ETFs, and to view full performance histories, please follow the links below:
Sources: Bloomberg Finance L.P., for the period 3-10 December 2020. Flows are as of date indicated and should not be relied upon as current thereafter. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.
1A 10 year average of weekly spreads using the Bloomberg generic 5Y BTP yield against the yield on the Bloomberg Barclays Euro Aggregate Corporates index. Data as of 10 December 2020.
2Morningstar, data to 30 November 2020 for European-domiciled ETFs.
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