European Investment Grade: The Advantages of Being Late to the Party
In Europe, the late start to the policy cycle gives the ECB some time to assess incoming inflation and growth data. The considerable amount of monetary tightening priced in by the market should provide a degree of protection to fixed income. Euro investment grade strategies offer higher yield and are typically shorter in duration than government indices and therefore should remain a core portfolio building block.
In early 2023, the roadmap for investing in fixed income markets seemed pretty clear. Falling inflation and gradually slowing growth indicated that the top to the Fed’s rate cycle was within view, and that was positive for most assets. Recent data has challenged that view. Activity has improved and the downward trajectory of inflation now looks likely to be a gradual glide rather than a dramatic decline.
Even in Europe, the significant disinflationary impulse from falling energy prices was expected to cause CPI to fall quite quickly. Things have not gone according to plan, however, with core CPI holding up. There could be seasonal factors behind some of this unexpected strength but it has forced central banks to sharpen their hawkish rhetoric. This more hawkish posturing has put markets on edge, with investors now keenly observing the data before deciding where to invest next.
The Second Mouse Gets the Cheese: Why It’s OK to Be Late Sometimes
The big fear is that the Fed’s Target Rate may have to rise significantly and with higher rates come the greater risks that the economy tips into a recession. While the ECB may be pushing a similarly hawkish line, the fact that it was so late to start raising rates means it is nowhere close to delivering the final rate rise. The Target Rate is at just 2.5% and the market prices a further 170 bps of tightening, with a 50 bp rise nailed on for the March meeting. While this approach is justified by inflation, the growth backdrop is not nearly as robust as it is in the US – euro area Q4 2022 GDP was flat.
The degree of tightening priced coupled with the soft growth environment should limit the risks that the ECB goes beyond what is currently priced. Indeed, recent comments from ECB member Ignazio Visco suggest dissent within the council as to how high rates may need to go. This could prove supportive for euro fixed income exposures. EMEA-domiciled euro investment grade ETFs have seen inflows of $3.7 billion year to date1, continuing to gather assets in February despite the weakness of returns.
Euro investment grade credit remains an interesting exposure for several reasons:
- Yields are relatively attractive: The Bloomberg Euro Agg: Corporates index indicates a yield to worst of close to 4.5%2. This is its highest outright level since 2011 and marks a dramatic move from just 10 bps in mid-2021.
- Favourable spreads: Credit spreads have tightened but the level of the option-adjusted spread on the Bloomberg Euro Agg: Corporates index remains close to the peaks seen in 2016 and 2019 so can hardly be viewed as rich. At 145 bps, the spreads are still approximately 25 bps wide to the 10-year average.
- Comforting duration: For an all-maturity corporate debt index, the duration is lower than the equivalent government exposure3. If yields rise then it should be less painful to be invested in a credit ETF than a government bond ETF.
- Credit quality holding up: There are few signs of a material deterioration in credit quality of issuers, with the upgrades/downgrades ratio for both Moody’s and S&P above 1 in Europe. They have recorded just one fallen angel each during Q1 so far.
In short, the higher yield and lower duration should provide some defensive posture for a portfolio. The obvious caveat is that wider spreads could lead to underperformance. However, if the US is any guide, around half of the negative returns in investment grade credit for February were driven by higher rate expectations rather than wider spreads.
Spreads may also come under pressure as a result of reduced purchases by the ECB. There are run-offs of EUR 2.56 billion per month over the coming 12 months from the CSPP portfolio, of which only a portion will be reinvested4. There is a twist. As the ECB notes, “the Governing Council decided on a stronger tilting of its corporate bond purchases towards issuers with a better climate performance during the period of partial reinvestment.” These purchases run until June 2023 and could provide relative support for ESG-aligned strategies.
Soaring energy prices and a focus on defensive companies meant 2022 was not perceived as a good year for ESG. That said, not all strategies underperformed. Figure 1 shows annualised returns against volatility, plotted over 1, 3 and 5 years to 28 February 2023 for the Bloomberg SASB Euro Corporate ESG ex Controversies Select Index against the Bloomberg Euro Agg: Corporate index. The Bloomberg SASB Index had higher returns than the market-weighted parent index during all three periods. Volatility has been higher over the past 12 months for the Bloomberg SASB ESG index but over the longer time periods has been lower.
Figure 1: Annualised Returns vs. Volatility
For these indices, the approach to index construction aims to maximise the ESG score while at the same time requiring the alignment of sector and other risk characteristics with the parent index. This design aims to reduce risks of material divergence with the market-weighted index. For this reason, these strategies can be used as core building blocks for benchmark-aware ESG investors.
An attribution of the Bloomberg SASB ESG Index versus the Bloomberg Euro Agg: Corporate index for 2022 demonstrates the value of the dual optimisation objectives. Asset allocation, largely the difference in sector allocations, was still a drag on the performance of the Bloomberg SASB ESG Index but by just more than 9 bps. However, this was more than offset by security selection, which resulted in 42 bps of outperformance5.