Insights
Euro Investment Grade Credit – Caught in a Yield Downdraft
European investment grade (IG) credit has made a convincing recovery after its September wobble. A rebound in equities, despite uncertainty over the resurgence of the pandemic, has encouraged market participants to re-enter risk positions. A step up in corporate bond purchases by the ECB, while primary issuance has started to fade into the end of the year, has also helped the dynamic. Indeed, the option-adjusted spread on the Bloomberg Barclays Euro Aggregate: Corporates Index has tightened to around 110bp, its tightest since 27 February 2020.
Further spread narrowing remains possible but is likely to be slower. The decline in the Bund yield, deep into negative territory, has created a strong downdraft for spread assets, dragging their yields lower. As Figure 1 illustrates, IG corporate yields may have fallen, but other risk assets, in this case 5Y Italian BTP yields, have declined even faster. Over the past 10 years it has been unusual for the 5Y BTP to trade with a yield below that of Euro IG credit. The only sustained period was in 2015-16 while the ECB bought government debt but not corporate bonds – CSPP (Corporate Sector Purchase Programme) purchases of credit started in June 2016.
There may also be specific reasons for the strong performance of peripheral bonds in 2020 with the EU’s Recovery and Resilience Facility, its centrally funded plan to recover from the pandemic, seen compressing intra-Euro spread risk. However, the bigger picture is that, as yields head down into negative territory, assets offering yield pick-up are going to be an increasingly important source of returns.
Figure 1: All risk asset yields have been dragged lower by negative rate policy
There are clearly some risk events during the remainder of 2020, not least the US election. This may cause some investors to pare back exposure to risk but the better rating of IG paper and, with the ECB buying backstop still in play, the potential for a meaningful sell-off looks limited. The September episode of risk aversion as COVID-19 infections started to rise saw option-adjusted spreads on the Bloomberg Barclays Euro Aggregate: Corporates Index widen 7bp, a move that took just 12 working days to reverse.
Aside from risks around the election itself, the longer-term concern is that a new US administration could introduce fresh legislation that would not be seen as positive for stocks. With much of this legislation likely to be environmental, one way to reduce the impact is through a focus on ESG investments.
There are also risks closer to home. ECB President Christine Lagarde has recently highlighted that the ECB’s strategy review will look at whether it should continue to buy corporate bonds on a ‘market neutral’ basis or whether the purchases should take other considerations into account. This mainly refers to environmental factors after environmental groups have criticised the ECB for offering cheap funding to big polluters such as oil companies and airlines.
The Bloomberg SASB Euro Corporate ESG Ex-Controversies Index excludes issuers from the parent index that are involved in or that derive significant revenue from operations related to extreme event controversies, controversial weapons, UN global compact violations, thermal coal extractions, tobacco or civilian firearms.
From the remaining issuers in the parent index, those without an ESG score available are removed. The index is then optimised by selecting securities and their corresponding weights to maximise the ESG score while maintaining similar risk-return characteristics of the parent index. The optimisation process allows this ESG strategy to be used as either a complement or instead of a core allocation to Euro Corporate for benchmark-aware and ESG-focused investors.
How to Play this Theme:
For investors seeking to exclude certain practices, industries or product lines, we now offer the SPDR Bloomberg SASB® Euro Corporate ESG UCITS ETF. The ETF follows an embedded ESG approach that builds on SASB’s materiality map to maximise the ESG score via a best-in-class/positive screening methodology. To learn more about this ETF, please visit its fund page.
Flows
European-Domiciled ETP Segment Flows (Top/Bottom 5, $mn)
European-Domiciled ETP Asset Category Flows ($mn)
Sources: Bloomberg Finance L.P., for the period 8-15 October 2020. Flows are as of date indicated and should not be relied upon as current thereafter.