Fixed income: our medium-term playbook

The bear is long gone, but beware of Goldilocks

	Sandro Croce CIO, Fixed Income
	Philipp Burkhardt, CFA Fixed Income Strategist and Portfolio Manager

 

Need to know: Unrealistic market expectations regarding the degree of easing likely in 2024 have cooled somewhat, while the Federal Reserve and other central banks continue to flag rate cuts in the second half of the year The macro environment is increasingly positive, but investors shouldn’t rely completely on a goldilocks scenario of inflation easing to target levels and growth close to potential amid an easing cycle Curves will normalise as central banks start cutting rates, creating a strong argument for allocating cash to fixed income ahead of these moves to lock in attractive yields and the diversifying influence of duration

 

No more bear but a little less bull

In the Q1 issue of Alphorum, we focused on the Federal Reserve’s (Fed’s) sudden and decisive December pivot. While there were plenty of reasons to view its actions as positive for fixed income, we felt the central bank risked overplaying its hand by allowing for multiple rate cuts in 2024. Meanwhile, the market’s reaction seemed close to irrational exuberance, with participants pricing in aggressive easing of up to seven fed funds rate cuts – far more than what the median of three indicated by the Fed’s dot plot. After the long bond bear market, such enthusiasm was understandable. But was it warranted?

Since then, the market has dialled back expectations of the potential level of rate cuts by year end somewhat, while there are growing signs that the time for reducing rates is approaching; in Europe inflation is slowing markedly, although in the US the evidence from indicators is less clear cut. While the Swiss National Bank (SNB) cut rates in March on the back of falling inflation and labour data, our base case is that rate cuts will come later than originally expected for most countries (probably from June). They may also be shallower, particularly in the US, as long as the data remain strong. It will therefore take more time to reach a neutral rate in most economies than markets originally anticipated.

In the US itself, the tightness of the labour market is easing while growth is holding up reasonably well. A question mark remains over inflation, but in recent remarks Fed Chair Jerome Powell indicated the slight rise in consumer price inflation in February (up 0.1% from the previous month to 3.2%) would not “materially change the overall picture”, which is one of “inflation moving down to 2% on a sometimes-bumpy path”.

Overall, this is generally a good recipe for markets. Indeed, investors are showing a renewed appetite for risk: equities have been hovering around all-time highs and strong investor demand for credit issuance has led to tighter spreads. However, given the asymmetric nature of bond returns, it befits fixed-income investors to think about what could go wrong.

 

Beware of relying on a goldilocks scenario

On the face of it, there are plenty of reasons to be cheerful. Look deeper, however, and there is a risk that markets are counting on something of a goldilocks scenario in which inflation continues to ease towards target levels, growth approaches its potential as the easing cycle gets underway (see figure 1). But in reality there remains the question: what happens if inflation plateaus or even begins to rise?

 

FIG 1. Market pricing: from ‘higher for longer’ to goldilocks

Source: LOIM, Bloomberg at April 2024. For illustrative purposes only.

 

In our view, the US labour market will be key in providing the answer. Strong labour markets and solid wage growth – not to mention booming asset prices – imply strong consumption as people feel they are better off and have money to spend. This would lead to a slower easing of increasing inflationary pressures, with the potential outcome of rate cuts having to be pushed back, causing a delay in the easing cycle.

For now, although the Fed is clearly signalling its next move, the central bank remains hesitant until it judges the temperature to be just right. The stakes are high in terms of its credibility, and currently the evidence is far from compelling. For the SNB, Swiss inflation is at 1.2%, the labour market is turning, and growth is at 1%, presenting a clearer case for cutting rates. But in the US, growth and inflation both remain above 2%, making the argument for easing much weaker. The last thing the Fed will want to do, if possible, is to cut rates only to have to raise them again a few months later.

On the other hand, it’s important to remember that unlike most other central banks, the Fed has a dual mandate to ensure not just price stability but also full employment; its rationale may therefore be more focused on the unemployment rate. This is usually the last economic indicator in a cycle to react, so it tends to be given a lot of attention. The central bank may be relatively more prepared to let inflation run a little hot if that supports the labour market, and also to deploy stimulus sooner – which is generally supportive for markets.

Ultimately, we will only know after the fact whether the Fed gets its timing just right. However, we can be sure that when it does start to cut rates, it will continue to closely monitor key economic indicators and adjust the pace of easing if necessary. Overall, while we believe the Fed may end up moving a little early, this is unlikely to be a recipe for disaster. If necessary, it will adjust its course, but there is little possibility of having to reverse it and hike rates, in our opinion.

 

Default risk cools

With rate cuts likely to start this year, the threat of rising credit-default risk from the looming maturity wall has eased noticeably. Just a few months ago, rates were at 5% and risked moving higher, while at the same time risk premia for defaults or credit spreads were significantly wider, leading to much higher all-in yields. For weaker businesses this meant refinancing was more difficult and default risk correspondingly higher.

Today, with both Treasury yields and credit spreads having moved lower and the Fed fund rate expected to fall, a virtuous cycle is forming in terms of default risk. Some lower rated issuers have already been able to access markets, while others will be better able to bide their time. As a result, while there will be idiosyncratic cases, overall default risk is likely to rescind as long as rates head downward. You can read more about refinancing and idiosyncratic risk in the corporate credit section of this issue of Alphorum.

 

Cash starting to burn a hole

This evolving scenario has been challenging for portfolio positioning. We expected that persistent inflation and ongoing growth could force the Fed to keep rates higher for longer than markets were pricing in earlier in the year. However, so far, the central bank has held its nerve and after its March meeting continued to signal three rate cuts in 2024.

Cash and money markets received a lot of inflows during the hiking cycle. We have ourselves been overweight cash due to our expectation that rates would move higher once markets adjusted excessive rate-cut expectations. High cash rates lower the opportunity cost of holding the risk-free asset, while volatility is reduced. However, assuming the Fed and ECB start to cut rates as expected towards the end of the next quarter, cash will become less and less appealing. If investors fail to deploy into longer duration assets, they risk missing a significant rally like the one in November and December 2023.

We have also had a bias in credit towards the better-quality end of high yield (HY) over investment grade (IG), as it offers higher carry than IG while being less rate-sensitive. Overall, credit fundamentals remain healthy; while default rates have risen in isolated areas such as real estate, in general there is no contagion. IG saw a lot of inflows last year, but in the wake of the Fed pivot and falling inflation figures, investors have been allocating more to HY. The environment’s relative stability inspires confidence: growth remains surprisingly strong, leverage levels are not excessive, and while interest coverage ratios are starting to deteriorate, they are still healthy.

Yield curves will normalise as central banks start cutting rates, so there is a strong argument for allocating to fixed income earlier rather than later – to lock in attractive yields while adding potential outperformance over cash through duration and price gains. We are therefore ready and biased towards going longer in terms of duration, by deploying cash into credit (either into IG or directly into the higher quality end of HY) and into Treasuries. We would continue to avoid the lower rated end of HY, where refinancing and default risk is more of an issue.

 

Key milestone for our TargetNetZero funds

As part of changes to its operational framework for implementing monetary policy announced in March 2024, the ECB announced a secondary target to support the European Union’s (EU’s) transition to a green economy by incorporating climate change-related considerations into its structural monetary policy operations. This is likely to involve providing liquidity through sustainability-targeted lending operations as well as the purchase of green bonds. Late April sees the three-year anniversary of the first of our TargetNetZero strategies – see the sustainable fixed income section for insights into how the portfolios have progressed over this period.

Source: LOIM at 31 March 2024. For illustrative purposes only.

Tactically capturing duration

Nic Hoogewijs, CFA  Senior Portfolio Manager

 

Need to know: As we flagged in the Q1 issue of Alphorum, historically, sovereign bond markets tend to perform well in the run-up to a first rate cut. Most central banks are now signalling a strong intention to start easing in the near future Investors’ attention should now turn to the medium term, in our view. On balance, we expect policy rates to fall sharply across developed markets over the next 18 months to something close to a neutral rate However, central banks’ policies remain highly data dependent, creating the potential for volatility. We therefore remain modestly overweight sovereign bonds while seeking tactical opportunities to add exposure

 

Fundamentals and macro

Across fixed-income markets, the dominant theme for debate in 2024 so far has been the expected timing of the start of easing cycles by central banks, along with the scale of rate cuts that can be expected. A growing consensus has emerged, with major central banks, led by the Fed and the ECB, guiding financial markets towards initial rate cuts from the midyear.

The general direction of travel for most central banks is clear, but the journey for each will be different. The SNB stood out as the first developed-market (DM) central bank to act, lowering its policy rate in March amid sharp downward revisions in its inflation projections. The Norges Bank, on the other hand, signalled its easing cycle is set to start later this year – most likely around the end of the third quarter. Meanwhile, the Bank of Japan continued to march to the beat of a different drum, finally lifting its policy rate out of negative territory and scrapping yield-curve control at its March meeting, in the context of faster-than-expected wage rises.

Despite clear signalling on timing, the extent of easing remains highly data dependent and subject to significant uncertainty. In the US, economic data published in the first quarter of the year surprised on the upside, with the Federal Open Market Committee (FOMC) revising its growth and inflation projections upwards at the March meeting. However, despite revising its core personal consumption expenditures (PCE) forecast up to 2.6% in March (from 2.4% in December), the Committee maintained its median forecast of three fed funds rate cuts of 25 basis points in 2024. Chair Powell dismissed the uptick in inflation, stating that “the story really is essentially the same”.

The FOMC’s stance conveys a strong willingness to start dialling back restrictive policy. However, whether it can deliver ongoing rate cuts will crucially depend on squashing lingering inflation pressures over the coming year. Current market expectations are for the fed funds rate to come down to what we estimate to be a neutral figure of around 3.5% by the end of 2025.

In emerging markets (EMs), central banks are mostly ahead of DMs in their easing cycles. In March, Mexico became the last country in South America to start easing. Meanwhile, in Eastern Europe, Hungary and the Czech Republic continued to cut rates to support their economies – although Hungary slowed the pace of easing in an attempt to provide some support to its severely weakened currency.

 

Sentiment

In common with other financial condition indicators (FCIs), the Fed's own FCI-G index has pointed to a consistent easing in conditions in recent quarters (see figure 2). Strong equity-market performance has been a major contributor, while peaking mortgage rates in Q4 2023 provide another important sub-indicator.

 

FIG 2. The Fed’s FCI-G Index indicates that inflation has decreased in recent quarters

Source: Bloomberg, LOIM at March 2024. For illustrative purposes only.

 

The signal conveyed by the index contrasts with the tight monetary-policy stance implicit in the real policy rate, as calculated by adjusting the effective fed funds rate (EFFR) for core inflation based on the year-on-year increase in the consumer price index. Given that inflation has fallen sharply over recent quarters while the EFFR remains unchanged at 5.375%, the real policy rate has risen over the past year. In fact, it is set to remain elevated even if the Fed starts to cut the fed funds rate (see figure 3).

 

FIG 3. The drop in year-on-year core price inflation should keep the effective fed funds rate elevated in 2024

Source: Bloomberg, LOIM, J.P. Morgan at March 2024. For illustrative purposes only.

 

The key question on the mind of investors is whether the tight monetary policy stance indicated by the real policy rate is supporting the Fed in its policy objectives, or if in fact easier financial conditions are thwarting the bank’s efforts to normalise price pressures. If the former is the case, the Fed will indeed have room to start easing soon. However, if the latter proves true, it may still be forced to keep rates higher for longer. When this point was raised at the FOMC’s March press conference, Chair Powell’s response was to downplay the significance of FCIs and point to cooling labour demand as a sign that financial conditions are indeed restrictive.

Overall, while we acknowledge that persistent easing in FCIs could support pricing in a relatively shallow easing cycle beyond 2024, we continue to monitor overall financial conditions closely.

 

Technicals

While net supply is increasingly heavy, historically attractive yield levels mean we do not see this as a major concern. The US Treasury quarterly funding announcement at the start of the year was well received, and no further increases are expected for several quarters. Meanwhile, Chair Powell’s comments suggest the Fed may announce a slower pace of balance-sheet reduction as soon as May. 

In Europe, private investors continue to step up and at least partially absorb record supply. As evidence, recent bond issuance has been notably oversubscribed, while eurozone overnight deposits are down in excess of EUR 1 trillion since August 2022. We expect deposit outflows to persist in 2024 as savers turn to sovereign bonds to lock in yields with longer duration. Meanwhile, at a global level, J.P. Morgan estimates that year-to-date bond fund inflows are robust at USD 188 billion.¹

 

Valuations

The broad-based year-end rally in sovereign fixed income triggered by the Fed’s December pivot was largely unwound in the first quarter, with interest rates at the index level rebounding to where they traded at the end of November 2023. This puts sovereign bond yields back in quite attractive territory, both from a historical perspective and on a relative basis.

Long-dated Treasury Inflation-Indexed Securities (TIIS) saw their real yield trading in excess of 2%. To put that in perspective, if purchased at the current real yield of 2.10%, the US TIIS 0.75 02/15/2042 will appreciate by 45% in real terms, with inflation compensation coming on top of that.² That makes it look attractive next to current US equity valuations, given elevated P/E ratios. It should be noted, however, that current market valuations price in a trajectory of sustained easing for major central banks. Ultimately, this remains conditional on inflation fully normalising.

For EM sovereigns, exchange-rate sensitivity complicates the issue. A strengthening dollar has resulted in ongoing EM currency depreciation. However, the segment carries quite well, and overall performance is positive.

 

Outlook

With central banks clearly signalling the short-term path of interest rates, attention should turn to whether they can be expected to settle at a neutral rate in 2025. Consequently, fixed-income investors should be looking for opportunities to lock in yield with a longer duration, while paying close attention to economic data and its implications for central banks’ ability to follow through on easing.

In DMs, we expect current multi-year-high cash rates to fall sharply over the next 18 months, a course which is already largely priced into markets. Beyond the economic rationale for rate cuts, authorities have a vested interest in delivering low funding costs; quantitative easing programmes have turned government cashflows negative and contributed to sharply increasing the interest-rate sensitivity of record sovereign-debt piles (in the UK this has led to unusually outspoken criticism of the Bank of England’s Asset Purchase Facility by the Treasury Committee³).

For EM sovereigns, the situation is less clear cut. If Fed rate cuts go ahead as expected, the impact should be broadly positive for EM sovereigns. However, if the Fed proves a little less dovish than expected, a stronger dollar could put additional pressure on EM currencies and make it more difficult for central banks in these countries to continue easing.

Overall, as we flagged in last quarter’s Alphorum, historically, sovereign bond markets tend to perform well in the run-up to a first rate cut. In this environment, we remain modestly overweight sovereign bonds but are vigilant for opportunities to add exposure. Given the highly data-dependent context, volatility in economic indicators may trigger some further cheapening and provide attractive entry levels. We therefore favour a tactical approach based on choosing opportune entry points to add duration.

Sources.

Get out of cash, get into credit

Ashton Parker Senior Portfolio Manager and Head of Credit Research

 

Need to know: Bond-market optimism has returned and investor risk appetite is strong. With issuance oversubscribed, liquidity looks ready to flood back into the market The looming debt- maturity wall in 2025-2026 will mainly result in idiosyncratic cases and the poorer quality end of high yield. Issuers with healthy fundamentals now have more options to refinance For investors who feel confident that rates have peaked, now is the time to lock in yields offered by cheaper, longer-dated credit issuances – before the easing cycle begins

 

Compared to the prognosis six months ago, for credit investors the world seems to be in a much better place than expected as we start the second quarter of 2024. The promise of lower rates has seen market optimism return, bringing with it strong risk appetite from many investors. In this environment, bond issues are well oversubscribed, spreads have tightened and there appears to be money on the sidelines, boding well for market liquidity.

Less positively, however, a consequence of renewed investor enthusiasm for bonds is that IG spreads are extremely tight, offering only a very slight markup to the risk-free rate. That creates a constructive scenario for the better-quality end of HY, with healthy market appetite allowing more names to refinance.

 

Real estate remains highly attractive

As mentioned in previous issues of Alphorum, real estate is one sector where bonds have suffered more than what we believe is really deserved. Real-estate credit ratings are highly dependent on interest rates, which affect both valuations and the amount of debt firms can service. Largely for this reason, as interest rates rose in the latest cycle, real-estate bonds became incredibly cheap.

Following a Lazarus-like revival, real-estate credit is arguably now just ‘really cheap’, with spreads continuing to be significantly wider than for bonds of the same rating in other sectors (see the Systematic Research section of this issue of Alphorum for analysis relating to this phenomenon). Yet the risk of default, even at BB grade, is minimal. And if, as is widely assumed, sooner or later the direction of travel for rates is going to trend down, this will be highly positive for real estate.

Recently, even more volatile sector names such as Citycon⁴ have managed to refinance. In time, the realisation that the unsecured bond market is once again open for real-estate names should create a positive feedback loop. Our knowledge of the sector and of individual companies gives us confidence in this view, so while we have trimmed some BB-rated real estate to take some profit, we are long overall on the sector.

 

Idiosyncrasies rule

In the Q1 2024 Alphorum we predicted a scenario of rising idiosyncratic risk as central banks begin to withdraw credit-market support and rates remain relatively elevated – a situation that would demand strong fundamental analysis. Today, we see defaults rising in a range of sectors, although we would characterise this more as a normalisation from abnormally low default rates than a cause for real concern. As things stand, credit fundamentals are unlikely to deteriorate to the point that defaults become a major issue.

Having said that, there are multiple examples of firms with idiosyncratic credit stories which are struggling to refinance. French multinational IT services and consulting firm ATOS⁴ posted record annual losses of EUR 3.44 bn for the year to the end of December 2023. It has EUR 3.65 bn worth of debt due to be repaid by the end of 2025 but has failed so far either to renegotiate with creditors or to follow through on plans to sell off assets to raise funds. A planned rights issue was also cancelled.

Another example is debt management business Intrum⁴, which was recently downgraded from BB- to B by Fitch and placed on Rating Watch Negative.⁵ The agency cited the company’s increased risk of debt restructuring, along with high leverage and weakening debt coverage.

Meanwhile, satellite operator Eutelsat⁴ has suffered from declining revenues and EBITDA for several years, while significant outflows related to the rollout of Generation 2 satellites by its recently acquired OneWeb subsidiary are expected to lead to negative discretionary cash flow over the coming years. However, the successful completion of a EUR 600 mn bond offering at the end of March, combined with cash on the balance sheet, means that it will be able to fully refinance EUR 800 mn worth of senior-secured bonds due to mature in October 2025.  

Finally, Spanish pharma company Grifols S.A. ⁴ was downgraded to B+ by Fitch in March, reflecting the company’s high leverage and slower-than-expected deleveraging, as well as its heightened refinancing risk (the company has major bond maturities in the first half of 2025 of EUR 1.8 billion). The firm’s reputation has also suffered due to repeated accusations by a short seller of overstating earnings and understating debt, however, Spanish market supervisor CNMV recently absolved the company of any wrongdoing.

 

Good news for healthy high-yield issuers

Although the shadow of the maturity wall still looms, this will mainly affect CCC and B rated bonds. It’s important to be aware of idiosyncratic cases like the ones mentioned above, but for those companies that have access to markets, peak rates are helpful as they mean that funding decisions can be made rather than postponed.

The expectation of falling rates and ongoing access to the market means firms are likely to issue sooner but with shorter dates, in anticipation of lower rates in the not-too-distant future. One option for companies with bonds maturing in 2025-2026 is to issue a new bond now but keep the existing issuance outstanding to maturity rather than calling it. Instead, interest can be earned on the cash raised – which will be higher than the rate being paid for the outstanding bond. On the other hand, with Covid firmly in the rear-view mirror, market shocks looking less likely and debt more costly, some firms may simply choose to manage with less liquidity.

Having said that, while other issues have been involved, the biggest idiosyncratic failures we’ve seen recently have all come down to the ability to refinance. Most corporate treasurers will be willing to give up a certain amount of return to ensure their companies have sufficient liquidity to avoid becoming a forced issuer.

 

FIG 4. Credit defaults are concentrated in lower quality HY and the current distress ratio indicates no contagion

Source: LOIM, ICE BofA, Bloomberg at March 2024. For illustrative purposes only.

 

Beware the opportunity cost of staying in cash

Even for risk-averse investors, the current environment creates a strong argument for getting out of cash. True, IG credit offers little excess performance over the risk-free rate, but cash offers no duration. If interest rates start to fall, so will your returns.

On this basis, if you believe rates have peaked, now is the time to get out of cash and into bonds, locking in current yields through cheaper, longer dated issuances before central banks start to implement flagged rate cuts. While monitoring the market carefully for idiosyncratic risk, our preference is to assume some risk for the better potential returns offered at the top end of HY, as BB offers a materially better return than BBB.

Source.

Three years of TargetNetZero IG

	Ashton Parker Senior Portfolio Manager and Head of Credit Research
	Christelle Curt-Cognac Client Portfolio Manager

 

Need to know: Our pioneering high-conviction, low-turnover TargetNetZero global and European corporate investment-grade funds mark three years since inception this quarter These strategies employ our proprietary Implied Temperature Rise methodology to identify firms whose emissions-reduction strategies are aligning them with a 1.5°C world Having weathered the high volatility of 2022, the strategies’ focus on corporate fundamentals and forward-looking temperature analysis support their financial and climate objectives

 

At the end of April 2024, our TargetNetZero strategies mark three years since inception. In this issue of Alphorum, we take a closer look at the their origin, approach and outlook. 

 

Twin convictions

We see it as our fiduciary duty to help clients both manage the risks and capture the investment opportunities arising from the coming structural and secular transformation of the global economy. We also strongly believe that a truly viable approach to investing in net-zero transition must include select companies in ‘hard-to-abate’ sectors, as these industries will be vital to future economic growth and can make impactful emission reductions. Not only are decarbonising companies in these areas helping accelerate the shift to net zero, they are reducing their exposure to transitional, physical and liability risks and thereby adapting their business models for a 1.5°C world.

Launched in April 2021, the same year as the ECB launched its climate strategy, our TargetNetZero strategies employ a high-conviction, low-turnover approach to investing in IG credit with the ability to build opportunistic HY exposures of up to 20%. To achieve their performance and climate objectives, the strategies favour investing in labelled green, sustainable or social bonds subject to the availability of suitable investment opportunities and without any target allocation.

As these funds promote environmental or social characteristics, they are classified as Article 8 under the European Commission’s Sustainable Finance Disclosure Regulation (SFDR).

 

Targeting net zero

The need to transition to a global economy with net-zero greenhouse gas emissions is a defining challenge of our time, creating investment risks and opportunities. Commitments to address climate change span the world, with about 145 countries having committed to net-zero targets – including the major economies of the US, China, the EU and Japan.

With this in mind, the strategies are aligned with the Paris Agreement. Their key climate targets are:

• Targeting an Implied Temperature Rise (ITR) of 2°C or lower
• A commitment to making at least 10% of investments sustainable
• Ensuring exposure to harmful companies is at least 30% below the benchmark

 

To achieve these aims, we utilise various proprietary tools developed by our in-house sustainability team and leverage its market-leading research, covering areas such as:

• All-scopes emission assessments, including relevant indirect Scope 3 emissions
• Forward-looking estimates of emissions and ITR
• Ongoing monitoring and reassessment of decarbonisation progress
• Climate-focused engagement and stewardship

 

Our proprietary approach to ITR

In developing the strategies, we viewed many of the existing metrics being used to build low-carbon portfolios – for the differential exposure of individual industries, companies and securities to climate risks and opportunities and to the related financial risks – as insufficient for the purposes of long-term investment. Rather than using backward-looking carbon footprints as our guide, we sought a forward-looking approach.

Adopting the ITR concept, we developed our own science-based methodology to plot the decarbonisation trajectories of industries and companies. This allows us to assess issuers’ alignment with a net-zero future through scenario-based, judgemental analysis. Our ITR metric, which has been referenced by respected organisations including the Portfolio Alignment Team of the Task Force on Climate-Related Financial Disclosures (TCFD), allows us to summarise the highly complex climate challenge in a single figure.

Based on forecasted decarbonisation pathways on an industry-region basis, our ITR metric provides an assessment of the environmental footprints and transition pathways typical of each sector under a climate scenario of 2°C. This allows us to identify and favour businesses in hard-to-abate industries such as agriculture, cement, steel, chemicals, energy, materials, construction and transport that might have high carbon emissions today but are focused on decarbonising strongly and credibly going forward.

These companies with low ITR scores have the potential to make a disproportionate contribution to ‘cooling down’ the economy; we therefore call them ‘ice cubes’. At the same time, we seek to identify and avoid ‘burning logs’ ­– businesses likely to stay on high-emission trajectories – which risk becoming stranded assets or no longer being able to operate successfully in a net-zero regulated world.

 

FIG 5. The current alignment of TargetNetZero strategies to a range of temperature scenarios

Source: LOIM at March 2024. For illustrative purposes only. Metric subject to change.

 

Targeting upside by focusing on the downside

Our ITR metric enables us to identify issuers that are implementing a credible decarbonisation strategy aligned with the Paris Agreement, and which are likely to be relatively less exposed to transition risks than competitors in the same sector. We would expect these firms to adapt more successfully than peers as the world moves to a lower carbon economy, providing our analysts with additional confidence in their assessment of the long-term viability of the issuer.

Where we have strong conviction and confidence in an issuer’s long-term viability, we will generally invest further down the capital structure to benefit from the additional return. This results in a strategic overweight to subordinated debt including corporate hybrids, as well as Tier 2 and AT1 securities from financial issuers.

From a ratings standpoint, corporate hybrids are generally rated two notches below the issuer rating, as the bonds are structurally subordinated and there is potential for coupons to be deferred. In the event of default, the recovery would be minimal, but since these bonds are issued by IG issuers, we anticipate default risk to be close to zero.

We have considerable experience in investing in subordinated securities, with the LOIM Fixed Income team investing in the asset class since its inception over two decades ago. We therefore have a strong preference for this type of subordinated debt within our TNZ strategy, as it provides potentially attractive financial characteristics and enables us to help finance a net-zero future.

 

Engaging on net zero

We place stewardship at the heart of our sustainable investment approach, integrating engagement throughout the investment lifecycle through a cross-asset stewardship team. Engaging and acting as a constructive stakeholder to businesses helps us confirm – and reconfirm – that the companies we invest in are aligned with the sustainability transition and are best positioned to benefit from it.

We first seek to understand where companies stand in their sustainability journey, then constructively suggest the changes we believe are necessary to ensure success. Businesses that demonstrate firm intentions towards decarbonisation may have the potential to become recategorised as ice cubes once these intentions become actions. Conversely, companies that demonstrate an unwillingness to engage or to adapt their strategies are at risk of becoming burning logs.

 

Revolution followed by evolution

Developing a proprietary ITR metric as an integral part of our forward-looking approach to climate investing was an important step in our sustainable-investment journey – which we have deep conviction in.

Like all new disciplines, sustainable investing has gone through a process of evolution. As committed proponents, we are committed to playing our part in ensuring the discipline builds on solid principles and evolves to reach its full potential. We believe that both rigour and transparency are vital to this endeavour; we therefore welcome regulatory improvements and support greater standardisation, along with thoughtful critical debate around the challenges of investing sustainably while supporting the real economy through the net-zero transition.

We constantly seek to improve our methodology. In particular, we are currently working to address the following challenges:

• Achieving standardised reporting of data
• Addressing how auditors audit sustainability claims
• Measuring the ITR of financial companies and their portfolios
• Incorporating companies that may have a higher ITR but whose products are critical to reducing global warming

 

Some growing pains, but the (sustainable) bond is back

The high-conviction approach taken by our TargetNetZero strategies means that we are prepared to take on more risk than the benchmark, in a calculated way, and may allocate up to 20% in HY credit to achieve our performance objectives.

In 2022, high levels of market volatility were detrimental to portfolio returns. However, our conviction in the long-term viability of the businesses in whose debt we were invested gave us confidence in their ability to weather the storm of a rising-rate environment and negative sentiment. We held our positions, as befits a low-turnover strategy, and this decision subsequently benefited the portfolios.

In the past year, these positions – especially those in the debt of real-estate companies and our exposure to subordinated debt – have enabled the global and European strategies to outperform their benchmarks by 1.1% and 2.1% in net USD and EUR terms respectively.⁶

 

FIG 6. One-year performance of the TargetNetZero Global and European IG strategies

Source: LOIM at 17 April 2024. Performance shown is for the TargetNetZero IG Global NA (USD) and TargetNetZero IG Europe NA (EUR) strategies against the benchmarks of the Bloomberg Barclays Global Aggregate Corporates and Bloomberg Euro-Aggregate Corporates TR Index respectively. Past performance is not a guarantee of future results.

 

As discussed elsewhere in this issue of Alphorum, inflation is easing and central banks aim to reduce interest rates in the second half of 2024. This reduces default risk and creates a favourable environment for long-term fixed income over cash in general, and subordinated debt in particular, in our view. At the same time, the energy transition is progressing, boosted by the Inflation Reduction Act in the US and the EU’s Net Zero Industrial Plan.

This environment, combined with the active, integrated credit and emissions analysis we carry out and continue to improve, increases our conviction in the ability of out TargetNetZero IG strategies to meet clients’ financial and climate objectives.

 

Source.

[6] Source: LOIM at 17 April 2024. Performance shown is for the TargetNetZero IG Global NA (USD) and TargetNetZero IG Europe NA (EUR) strategies against the benchmarks of the Bloomberg Barclays Global Aggregate Corporates and Bloomberg Euro-Aggregate Corporates TR Index respectively. Past performance is not a guarantee of future results.

Spread compression and decompression dynamics in high yield

	Anando Maitra, PhD  Head of Systematic Research and Portfolio Manager
	Jamie Salt  Systematic Fixed Income Analyst and Portfolio Manager

 

Need to know: A key element of our tactical approach for some months has been to increase exposure to the higher quality end of HY in credit markets, with the aim of capturing carry while minimising default risk By analysing dispersion in corporate-bond markets through the latest hiking cycle, we can identify whether it offers potential alpha opportunities for active investors, with real estate a target for relative spread compression Based on our analysis, we expect spread decompression between high-quality and low-quality HY to continue as idiosyncratic cases persist and structural concerns remain subdued

 

Since last summer, a key tactical allocation for our fixed-income strategies has been an exposure to higher quality HY corporate bonds. The aim has been to capture the attractive carry of elevated yields while avoiding those issuers more exposed to impending refinancing needs.

As we showed in the Q4 2023 issue of Alphorum, this allocation is better positioned in a period of increasing dispersion among lower quality issuers. However, it can also benefit from declining dispersion within the higher quality bucket. Such declining dispersion often occurs when systemic shocks that are affecting entire sectors dissipate.

In this analysis, we take a deeper dive into dispersion in corporate-bond markets, assessing how it has developed through the latest hiking cycle and whether it has the potential to continue given the current state of markets. Importantly, please note that here we measure dispersion as the variation of spreads in a specific category at any given point in time.

 

Sectoral dispersion

The initial stage of risk-off moves tends to be indiscriminate, as allocators bluntly pull out of risk assets. While this type of activity sees spreads move higher, on a relative basis there is little increase in dispersion. However, once this first phase of de-risking has run its course, allocators become more discriminating, tending to focus on those sectors which are most exposed to the underlying cause. As a result, these sectors underperform. For instance, throughout the 2022-2023 hiking cycle, real estate was the most prominent loser due to the sector’s sensitivity to interest rates.

 

Spread compression in real estate?

In much the same way as an initial risk-off move drives a general widening of spreads, unfairly punishing sectors that are relatively insulated from the given shock, a more sector-focused sell-off still tends to punish single names that possess adequate balance-sheet strength. This ultimately causes a blanket widening in all names within the affected sector, triggering dispersion among spreads at a sector level. Figure 7 shows how real estate drove sector dispersion in EUR high-yield assets through H2 2022 and H1 2023.

 

FIG 7. Impact of real estate sector on EUR HY spread dispersion, June 2020 to December 2023

Source: Bloomberg Indices, LOIM Calculations. Note that we focus on EUR issuers here as the relative cheapness of HY real estate is more pronounced. However, a similar pattern can be observed in USD issuers. As of end of March 2024. For illustrative purposes only. Past performance is not a guarantee of future results.

 

To show the impact this has on valuations, Figure 8 compares the spread levels of all key sectors since the tights experienced in December 2021. We can see that while most sectors have reverted to being well aligned with prior levels, HY real estate remains a clear outlier in terms of relative cheapness.

 

FIG  8. Relative spread levels by sector, March 2024 vs December 2021 tights 
Hover over the data points to identify industry sectors

Source: Bloomberg Indices, LOIM Calculations. Note that we focus on EUR issuers here for simplicity and as the relative cheapness of high-yield real estate is more pronounced. However, a similar pattern can be observed in USD issuers. As of end of March 2024. For illustrative purposes only. Past performance is not a guarantee of future results.

 

Despite the outsized widening of HY real estate spread vs the local tights, the sector sub-class has already been a sizable outperformer year to date. It would therefore be reasonable to question whether the compression of real estate vs the rest of the high-yield complex has already run its course. However, in reality, the tightening in real-estate spreads has been in line with the substantially higher beta that comes with such extreme levels. As the entire HY complex has also compressed in the year to date, the relative spread levels of HY real estate versus the rest of HY – as represented by the spread ratio between the two – remains near historical highs (see figure 9). This holds even when excluding the lowest rated issuers (CCC and below). Ultimately, this underlines the fact that high-yield real estate remains extremely cheap on a relative basis.

While there is likely to be further defaults within the HY real-estate complex, these will be signposted by company fundamentals. What’s more, the majority of issuers will be able to find refinancing solutions, at least for the short term. We believe that this scenario continues to offer many alpha opportunities for active investors within the space as relative spreads compress.

 

FIG 9. Relative spread ratios of EUR HY real estate vs all HY sectors, and vs HY ex-CCC and below debt

Source: Bloomberg indices, LOIM calculations. As of end of March 2024. For illustrative purposes only. Past performance is not a guarantee of future results.

 

Idiosyncratic dispersion, not a structural widening

If sectoral effects were a key source of dispersion throughout 2023, in Q4 2023 and year to date in 2024, we have begun to see an increase in idiosyncratic issues beyond the real-estate sector. This has already had a sizeable and more broad-based impact on the dispersion of spreads in HY (see figure 10). Especially in EUR HY, a unique dynamic is emerging: high relative dispersion despite spreads being near tights, compared to very little dispersion within IG (even when stripping out the effect of the real-estate sector). 

 

FIG 10. Cross-sectional spread dispersion per unit of spread in HY markets, by z-score (excluding real estate)

Source: Bloomberg indices, LOIM calculations. As of end of March 2024. Z-scores calculated using full 2004-2024 period averages and standard deviations. For illustrative purposes only. Past performance is not a guarantee of future results.

 

This scenario might suggest that HY as a whole is experiencing high dispersion. However, digging deeper, we can see a large divergence within HY itself at the rating level, with BBs still exhibiting low dispersion per unit of spread (in line with IG), but B and below showing elevated and increasing readings (see figure 11). Moreover, this is occurring in an environment of low overall index spread levels.

 

FIG 11. Spread dispersion per unit of spread versus spread levels in HY markets, by z-score (USD)

Source: Bloomberg indices, LOIM calculations. Red dot represents end of March 2024. Note that here we use US index data due to the increased data history availability (1993-2024). Z-scores calculated using full 1993-2024 period averages and standard deviations. For illustrative purposes only. Past performance is not a guarantee of future results.

 

This is not only observable in cash bonds but is further exemplified when looking at the world of credit derivatives. Credit-default swap (CDS) index tranches reflect increasing risk as we move from higher to lower attachment points (where defaults are reflected in losses). For example, for the riskiest (0-10%) tranche, any default would result in a loss, while for the next (10-20%) tranche, only cumulative losses above 10% would be reflected. The riskiest tranches are therefore more sensitive to idiosyncratic moves, which can be affected by idiosyncratic credit events that have no impact on the more senior tranches. In systemic events where defaults are high, the higher tranches are much more affected in relative terms.⁷

Figure 12 compares the spread ratios of the highest tranche (20-35%, systemic or correlated defaults) and the lowest tranche (0-10%, idiosyncratic defaults) of the standard iTraxx Xover CDS index.⁸ It shows a clear trend that started towards the end of 2023 and has accelerated through 2024, in which expectations of a systemic default wave have fallen but at the same time expectations of idiosyncratic defaults have increased.

 

FIG 12. Spread ratios for iTraxx Xover CDS index versus selected iTraxx Xover tranches (0-10% and 20-35%)

Source: BNP Paribas, LOIM calculations. As of end of March 2024. For illustrative purposes only. Past performance is not a guarantee of future results.

 

Decompression in low quality vs high quality spreads to persist

The best way to play this theme moving forward depends on your perception of the evolving situation. Will idiosyncratic dispersion fall, or will broad spread levels increase, in accordance with a more structural narrative? Or will the current scenario continue, with higher idiosyncratic risk relative to structural risk?

In Q4 2024, we posited that the impending maturity wall would be a problem for low-quality issuers only, with those rated BB and above well insulated and capable of refinancing maturing debt at current levels. This prediction has so far proved correct, with bumper Q1 issuance at IG and BB level, while issuance of lower rated has been more muted. We believe this trend remains intact and that the year-to-date activity has actually further reinforced the scenario, since the refinancing of IG and BB-rated debt has improved the outlook for their balance sheets, whilst issuers rated B and below on the whole remain in a difficult position. Ultimately, we continue to recommend a preference for high-quality HY issuers as the best way to access carry while avoiding the fundamental minefield of low-quality HY.

In summary, while we see a case for continued and much-warranted spread compression in still-oversold sectors (namely real estate), we expect spread decompression between high-quality and low-quality HY to continue as idiosyncratic cases persist and structural concerns remain subdued.

 

Sources.