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Investment Grade Credit Sustaining the Middle Way
- In the current environment, we believe investment grade credit could be well suited for investors grappling with a variety of potential market scenarios in the coming months.
- We see four main reasons to like the asset class: support from central banks, yield pick-up versus government bonds, tight spreads and potential for gains following vaccine roll-outs.
The Current Landscape for Investment Grade Credit
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.
Four Reasons to Like Investment Grade Credit
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.
- Support from central banks. IG credit has the relative safety element of being supported by central bank purchases. In Europe in particular, ECB purchases have averaged EUR 1.8 billion per week during Q4 2020 to date. While the Fed has been far less active in the credit arena, the market is confident that the Fed can step up purchases in the event of market disruption.
- Still a yield pick-up versus government bonds. A yield spread pick-up to government bonds of 90-100bp means that owning IG credit is a positive carry trade. While investors may approve of the safety of government bonds over year-end, owning an asset that has negative carry is a challenge over anything but a short investment horizon.
- Spreads are tight. IG spreads may look fairly tight from a historical perspective but the wider trend of spread compression means that IG remains interesting on a relative basis, especially in Europe. For instance, strategies of picking up yield via investing in periphery government bonds may have played out. The 5-year Italian BTP has, on average1, yielded 25bp more than the yield on the Bloomberg Barclays Euro Aggregate Corporates Index; however, following the recent compression in spreads, 5-year BTPs now trade 35bp through the Corporate index.
- Still some potential for gains. Sector rotation may offer the potential for some further spread narrowing. Consumer cyclicals and energy, in particular, have lagged the performance of most other sectors. If the vaccine really is the silver bullet, signalling 2021 will bring a return to a more normal economic environment, then these sectors can play catch-up.
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.
Following the Flows
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.
How to play these themes:
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:
SPDR Bloomberg Barclays 1-10 Year U.S. Corporate Bond UCITS ETF
SPDR Bloomberg Barclays 10+ Year U.S. Corporate Bond UCITS ETF
SPDR Bloomberg Barclays Euro Corporate Bond UCITS ETF
European-Domiciled ETP Segment Flows(Top/Bottom 5, $mn)
European-Domiciled ETP Asset Category($mn)
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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