Fixed income: a bull steepener as rates peak?

Philipp Burckhardt, CFA  Fixed Income Strategist and Portfolio Manager

 

Need to know: Fixed-income investors are navigating another challenging year. Growth seems stable, but resilient US inflation and recent geopolitical events mean that although the fog is lifting, the path ahead is still not clear Yield curves can take on a variety of shapes. Historically, the sort of inversion seen in 2023 has almost always been followed by bull steepening. However, it pays to be prepared for less welcome scenarios We prefer to stay diversified and well-hedged, but ready to exploit emerging opportunities, balancing credit and rate risk, and favouring fundamentally healthy, cashflow-generative businesses

 

While 2022 was a terrible year for the bond market as a whole, the appropriate strategy for fixed income investors was clear – be long on credit and short on rates. During 2023, fixed-income performance has improved but is meeting steep competition from cash. 

At the time of writing, Treasuries had gained as markets sought haven assets as the Israel-Palestine conflict escalated. If the fighting spreads, and the battles draw in other regional actors, further risk-off moves would likely be in store and markets would contend with higher oil prices and assess any impacts on trade routes in the area. We do not have direct exposure to Israel in our Global Fixed Income Opportunities and credit strategies, and we continue to apply tail-risk and credit-default swap overlays to defend against market shocks.

With exogenous, macro and market forces in play, fixed-income investors need to find a way ahead. But unlike 2022, the overall situation – and therefore the best course of action – has become less clear. Here we focus on the potential shape of the US yield curve in order to plot next steps.
 

Inverted world

As a natural consequence of rates selling off massively in 2022, the front end of the yield curve moved up, creating an inversion. Traditionally this change in the shape of the curve presages a recession. There is certainly some evidence that growth is slowing, and with inflation calming down, central banks are cautiously signalling their expectation that rates are at or very near their peak for this cycle. However, the question for fixed-income investors is: will the traditional trajectory play out? Or are we in new territory for the global economy, and consequently in a different scenario for bonds? With this in mind, we will explore a range of possible scenarios, and set out our playbook for the next 12 months.
 

History lessons: four states of the yield curve

The bond curve can take on a variety of shapes, but it essentially exhibits one of four basic states: bull steepening, bull flattening, bear steepening and bear flattening. As we have already noted, in past cycles curve inversion has almost always been followed by recession and curve steepening. However, not all steepenings are alike.

Historically, there have been three key phases in the bond market that have brought different forces to bear on the shape of the yield curve. For several decades from the 1950s, the front end was almost always driving the curve, with the long end largely irrelevant. This lasted until 1985, when the ‘Great Moderation’ marked the start of a 30-year bull market for bonds. During this period, both the front end and the long end (and the interplay between them) became important. Then, in the wake of the global financial crisis, bond markets entered a third phase: the front end become irrelevant, as it was anchored at the zero lower bound, with the long end driving the curve (see figure 1).
 

FIG 1. Dominance of the front end of the yield curve during three rate regimes

Source: Federal Reserve, LOIM calculations as at October 2023. For illustrative purposes only.


Past behaviour indicates that once in a particular state, bond markets tend to stay there for a while – for example, 2022 was all about bear flattening. The key question for fixed income investors going forward is which of these three scenarios are we going to end up in? We consider a bull steepening rather than a bear steepening of the curve to be the likely scenario, but this outcome is not guaranteed. That is important to be aware of, because it potentially creates an either/or rates or credit scenario.
 

Reasons to be cheerful

While the signals are not entirely consistent, as the final quarter of 2023 progresses there is plenty for fixed-income investors to feel positive about. Monetary transmission takes time and central banks have had to adapt to economic surprises, but market participants are increasingly confident that rates are finally at or at least near their peak – although the potency of the ‘higher for longer’ approach is being tested by the resilience of US inflation in the October print. Central banks are sticking with the narrative that growth and inflation will converge to long-term trends, with the former continuing to rise or at least remain stable while the latter continues to fall. As this happens, it should support the case for a bull steepening of the curve, in our view.

At the same time, economies seem quite resilient. Six months after the US mini-banking crisis, no more obvious cracks are showing in the financial sector. Meanwhile, the commercial real estate sector – which was a source for concern – seems to have stabilised and its bonds have been performing better.

Within bond markets themselves, the correlation between rates and credit is clearly negative again, giving fixed-income investors some flexibility to adapt their portfolios to changing conditions. Finally, all-in fixed income yields are outright attractive. However, while the consensus view is that the fog is clearing and the outlook is broadly sunny, the path ahead is unlikely to be straight and narrow, and it is certainly not well-marked.
 

Top of the cycle: are we there yet?

While central banks are cautiously signalling that rates are approaching their peak, monetary policy remains reactive rather than decisive and key indicators are still not giving a 100% clear reading. With US inflation proving to be stubborn, and growth data and earnings resilient, higher for longer is an increasing likelihood. On an aggregate level, both monetary and fiscal measures are likely to remain tight.
 

FIG 2. US and European policy rates and yield curves

Source: Bloomberg, LOIM at October 2023. For illustrative purposes only.
 

 

Having said this, ultimately growth indicators are softening. While services are starting to weaken, manufacturing indicators are already quite subdued. Once excess savings – which are depleting rapidly – are finally used up in the next few months, prevailing financial conditions should finally start to act as a drag on consumer spending. There are also signs that the labour market is turning and wages are normalising, reducing the risk of second-round effects.

Credit offers attractive carry while the economic backdrop allows it, but it remains to be seen what will happen as monetary policy finally starts to bite. Higher financing costs should eventually start to impact corporates, which will need to decide whether to absorb them through lower margins or pass them on to the consumer (in a weaker environment, the former is more likely). A maturity wall means the EUR-denominated high-yield segment in particular is exposed to some refinancing risk, although this should be manageable (see the Systematic Research section for more on this topic).

For sovereigns, the long-awaited arrival of peak rates should provide some certainty. At the moment, investor demand for rates is healthy, but heavy borrowing, particularly by the US Government, could put pressure on at the long end and impact term premia.

Overall, if the hoped-for soft-landing scenario plays out successfully, with growth slowing but a recession avoided and inflation drifting down, the case for bull steepening is strengthened. But what if no real recession happens and inflation becomes sticky? Or demand drops and growth stagnates, but inflation remains elevated? In these scenarios, tactical credit and duration allocation will be key.
 

Stay in shape

Ultimately, we see a bull steepening as the most likely curve trajectory from here, but prefer to be prepared for less welcome scenarios. Understandably, the more inverted yield curves become, the more investors are drawn towards moving into cash. With the latest steepening, curves have normalised quite heavily. As a result, only a limited amount of spread is needed to offset the longer duration optically. Investment-grade bonds therefore look more attractive than high yield again from a relative valuation perspective.

However, ultimately, given the range of upside and downside risks, we believe the right approach is to stay diversified and hedge against ‘black swan’ events, while remaining poised to act tactically and exploit emerging opportunities. It pays to balance credit risk with rate risk and stay selective, avoiding the lowest-grade end of the credit market in favour of fundamentally healthy, cashflow-generative and sustainable business models that will be able to address higher refinancing costs in the next 12-24 months. That way, whatever happens to yield curves, your portfolio has the potential to stay in the best possible shape.
 

Developed-market sovereign debt leads our convictions for the coming quarter, as the opportunity to capture elevated yields amid peaking rates comes into view. We are also constructive on upper quality high-yield and local-currency emerging-market debt.

 

Nic Hoogewijs, CFA  Senior Portfolio Manager

 

Need to know: With policy rates higher than at any time since before the global financial crisis, high yields across markets and throughout the curve continue to weigh on sovereign bond market performance However, now that central banks are cautiously signalling the arrival of peak rates, option implied volatility is reducing; as a result, we expect investors to be increasingly keen to lock in historically attractive valuations Short-term developed market bonds already look attractive, while looking forward the valuation argument should make longer-term DM bonds appealing; for emerging market sovereigns, credible central bank policy will be key

 

Fundamentals and macro

The unusually reactive monetary policy approach by central banks in this cycle kept debate about additional tightening alive over the summer. In the event, September saw policy diverging to reflect local conditions. The Federal Open Markets Committee paused rates at 5.375% but left the door open to further hikes, pointing to ongoing low unemployment and still elevated inflation. In the Eurozone, the European Central Bank (ECB) took the policy rate to 4% with a further 0.25% hike, while signalling a hawkish pause. The Bank of England surprised markets by going on hold, while the Bank of Japan, having announced a more flexible yield curve control framework in July, left rates unchanged.

Emerging market (EM) central banks are more advanced in their respective tightening cycles, allowing countries including Chile, Brazil and Hungary to start reducing their policy rates. However, for EMs the yield advantage is key to maintaining foreign exchange rate stability. That is particularly the case in the current scenario of elevated developed market real rates and broad-based US dollar strength – as the Polish central bank learned to its cost when it stunned markets with a 0.75% rate cut in early September.

A broad array of market indicators confirm financial conditions have tightened significantly. However, uncertainty around the lag in transmission to the real economy remains elevated. Although the rate of inflation continued to decline in the third quarter, this was mainly due to disinflation in energy and goods, the main part of which is probably behind us. To bring annualised inflation down to the 2% target from its current 4%-5% level, progress in the services component (ex-shelter) is needed. The latest data suggest that labour market conditions remain tight and core services inflation continues to run hot. Central banks will therefore need to stay the course with restrictive policy rates until aggregate demand slows and labour markets ease.
 

Sentiment

Sovereign bond markets underperformed in the third quarter, which was marked by a pronounced bear steepening of the yield curve. The Bloomberg Global Treasury Index (EUR Hedged) fell 2.35% over the period, with the long-maturity segments underperforming sharply. However, while rising yields continue to weigh on performance, interest-rate increases this year have been much less dramatic than in 2022, with the 5-year US Treasury yield up 0.61% year to date, compared with 2.74% in 2022¹. 

The dramatically improved yields on offer in sovereign bonds contributed to keeping overall year-to-date market performance close to flat. This stands in stark contrast to the double-digit negative returns (-12.72%) that sovereign bond investors weathered in 2022¹. Admittedly, cash has continued to outperform sovereign bonds in 2023, with the FTSE EMU (European Monetary Union) 3-month EUR showing a year-to-date return of 2.26%1. However, with major central banks starting to signal the potential peak of their respective tightening cycles, option implied volatility for indicators such as 1-year-1-year swaps show policy rate uncertainty is finally coming off its multi-year high. Taken together with elevated yields, this reinforces the case for sovereign bonds generating positive returns. With sovereign bonds also having regained their role as a diversifier, we expect investors to be increasingly keen to lock in historically attractive yields.
 

Technicals

TNet supply remains a headwind for sovereign bond markets, and its importance will increase as central banks start to accelerate their quantitative tightening programs. The Bank of England has already announced an increase in balance sheet reduction from GBP 80 billion to GBP 100 billion per year, while the ECB is set to have a more active debate on the size of its balance sheet now that it has signaled a pause in rate hikes. For the Fed, meanwhile, the balance sheet run-off could extend beyond 2024. 

Fortunately, elevated supply looks set to be met by additional private sector demand. JP Morgan estimates bond funds have attracted net purchases of nearly USD 460 billion in 2023, with the Belgian DMO raising an unprecedented EUR 22 billion via one attractively priced 1-year note alone². With banks failing to pass on prevailing market rates to their retail clients, the incentive to shift deposits into alternatives such as money market funds and short-term bonds is increasingly compelling. 

Despite this healthy demand, yields rose further in Q3, particularly in the long end. The main driver appeared to be the sustained strength of some economic indicators, which led central banks to nudge their peak policy rates higher than first anticipated and indicate they will stay higher for longer. The Bank of Japan’s adoption of a more flexible yield curve control policy was also a potential headwind, since this made domestic sovereign bonds more appealing to Japanese investors, who are traditionally active in foreign bond markets. However, so far, the impact seems muted. We put less weight on the US downgrade by Fitch and fiscal sustainability concerns as catalysts for rising term premia, given that the swap spread remained relatively stable.
 

Valuation

From a historical perspective, valuations are attractive. Nominal yields hit fresh multi-year highs across regions, with many segments hitting pre-GFC levels. More importantly, sovereign bond prices look particularly attractive both in real terms and from a relative perspective.

Focusing on US Treasuries, in Q3 the bear-steepening was mostly driven by a rise in real yields (see Figure 1). Treasury inflation-protected bonds now trade at a real yield of over 2% across the curve¹. To put that in perspective, if purchased at the current real yield of 2.38% the US TIIS (Treasury Inflation-Indexed Security) 0.75 02/15/2042 will appreciate by 54% in real terms , with inflation compensation coming on top of that.

FIG 1. Bear steepening: the US Treasury yield curve in Q3 2023

Source: Bloomberg, LOIM as at 30 October 2023. For illustrative purpose only.

Elevated real yields for sovereign bonds are also attractive when compared with equities, providing a competitive ‘real’ value proposition both in absolute and relative terms. To illustrate this, Figure 2 compares US 10-yr Treasury real yields with the 12-month forward price-to-earnings ratio of the MSCI US Index.

FIG 2. Real sovereign bond yields are also cheap relative to equities  
 

Source: LOIM as at 30 October 2023. For illustrative purpose only.
 
 

Outlook

With central bank policy rates likely to linger in highly restrictive territory, the yield on short-term bonds should offset any further incremental rises in short-term interest rates. While some underperformance versus cash remains a near-term risk, on balance the segment is attractive to a broad range of investors.

Long-dated bonds are less protected by yield and central bank policy, while elevated net supply could represent a significant near-term headwind. However, looking ahead the valuation argument should dominate. Once tighter financial conditions finally hit the economy in earnest, investors will be looking to lock in historically attractive real yields, creating significant potential for capital appreciation for long-term bonds.  

On balance we are neutral on local emerging market bonds. With the JP Morgan GBI-EM index rate trading close to 7%, we still see potential for the segment to do well if EM central banks follow a credible path like that taken by Brazil. We remain cautious, however, on Chinese local currency bonds. While an attractive diversifier, they offer lower carry than other EMs, and China faces ongoing headwinds in the form of property sector concerns, tensions over Taiwan and accommodative monetary policy in the context of low inflationary pressures. 
 

Denise Yung Senior Credit Analyst and Portfolio Manager

 

Need to know: The collapse of Silicon Valley Bank and the subsequent mini banking crisis in the US may have caused jitters earlier in the year, but the current economic environment is largely favourable for the financial services sector We favour European banks over their US counterparts – greater dispersion due to issues such as commercial real estate exposure and concentrated deposit bases means care and attention is required with US names We tend to prefer the value found in the subordinated part of banks’ lending structures and continue to see value in AT1s – at the right price and from the right issuers

Bonds issued by financial services firms are traditionally found at the quality end of the fixed income spectrum, where they make up a notable proportion of the investment grade market. However, after the collapse of first Silicon Valley Bank, then Credit Suisse and subsequently First Republic Bank earlier this year, investors could be forgiven for wondering whether banks’ debt securities belong in a high-quality fixed income portfolio. In this quarter’s Alphorum, we explain our position on financial services debt, and why we still see European banks, in particular, as an important part of a diversified portfolio.
 

Europe vs US: structural differences

Firstly, it’s important to be aware of three key differences that make the crisis at US regional banks earlier this year unlikely to occur in the European banking sector.

1. Regulation is more consistent
   A key factor in the issues was that smaller US banks are less strictly regulated than larger   ones – in Europe, safety measures such as capital and liquidity rules apply to the entire sector.
2. Banks hedge interest rate risk more effectively
   Some regional US banks tied up too much capital in low-yielding assets. As rates and thus funding costs rose, these banks experienced a severe squeeze on their net interest margins. European banks hedge more, and for regulatory reasons they do not take similar interest rate risk.
3. Less concentrated deposit base
   SVB and First Republic⁴ both had heavily concentrated deposit bases, with significant quantities of uninsured deposits. This concentration effect, exacerbated by easy electronic withdrawal and social media contagion, resulted in sudden, large deposit outflows. European banks tend to have more diversified deposit bases.

US banks are likely to face a tighter and more comprehensive regulatory environment going forward, whereas European banks have already adapted to stricter regulations put in place over the past decade. Bank runs can of course still happen in Europe – this is an area the ECB is currently looking into and may seek to address through regulation. However, European banks are generally in a stronger position than their US counterparts in terms of capital, liquidity and asset quality – the notable exception of Credit Suisse this year can be considered idiosyncratic in this respect.
 

Asset quality: a waiting game

From a credit perspective, we are still watching the quality of banks’ assets very closely. Most are reporting benign asset quality with little deterioration in their portfolios. A lot of the weakest businesses were wiped out during the pandemic, so the quality of surviving companies is generally good, and many have enjoyed a boost from reopening trade.

Consumers and corporates are starting to use up their cash balances, but not to alarming levels. Loan growth is evident in consumer credit cards, but this is a regression back to pre-pandemic levels rather than anything more serious. Overall, both corporates and consumers are proving resilient. Some deterioration can be expected once tightening starts to bite; more cautious banks are ensuring additional provision in the form of a management overlay on top of what models suggest. Generally speaking, though, while vigilant for any signs of deterioration in the companies they are lending to, European banks are comfortable.
 

Revenue: a growing issue?

Another issue to consider is revenue – specifically, where revenue growth will come from for banks now that interest rates are at or near their peak. Banks expect the increase in their net interest income may start to slow but still see room for growth, particularly in periphery countries, where deposit betas (a measure of the extent to which interest rate rises are passed through to depositors) have remained unexpectedly low. However, with new income from interest waning, banks are putting more focus on fee income from additional services such as insurance and asset management. Cost control is another important theme, with banks taking expense management measures such as rationalising their branch networks and optimising staffing levels. Many are also investing in technology, which despite the upfront cost should provide benefits to the bottom line.
 

FIG 1. European banks: historical spread levels (3 years trailing, bps)
 

Source: Bloomberg, LOIM at October 2023. For illustrative purposes only.

 

Do banks have a ‘real’ problem?

One area of potential concern is commercial real estate. Many US regional banks are still significant players in this market, creating a potential feedback loop as conditions tighten – mainly for banks with heightened exposed to office property in urban areas such as Manhattan. In contrast, most European banks managed down their real estate holdings in the wake of the global financial crisis, with lending for the sector shifting to non-bank entities such as real estate investment companies. As a result, most European banks have less than 10% of their loan book in commercial real estate (for US banks, that figure can be 20-30% or even more). 
 

AT1s: no more tiers to be shed

Fixed income investors are understandably still smarting from the total write down of Credit Suisse’s additional tier one (AT1) bonds in March. However, it should be remembered that Swiss lawmakers literally changed their rules to enable the write down. In the wake of these events, Eurozone regulators clearly reasserted that under their watch, AT1s should only be written down once all equity capital is exhausted. 

Credit Suisse’s inheritor, UBS⁴, will need to come to market at some point to optimise its capital stack, since its current excessive use of equity to cover capital requirements is inefficient. The bank is considering changing the structure of its AT1s to make them more attractive to investors. A popular recent approach from banks has been to tender their existing AT1s at the same time as issuing new ones, thereby ensuring investors have money available to invest in new AT1s while avoiding additional interest costs. This may be an attractive way for UBS to improve investor sentiment towards the Swiss AT1 market.
 

Climate risk: a clouded issue?

One area where we feel banks could be doing more is sustainability. While most are pushing the companies they lend to on sustainability, their own levels of disclosure are generally poor. The ECB has elicited some disclosures regarding climate risk from banks and conducted climate-specific stress tests. However, so far this has been an information- gathering exercise.

Admittedly, providing granularity on Scope 3 indirect emissions from specific assets or loans is difficult for banks, due to both client confidentiality and the sheer scale of modelling required. Despite efforts to improve disclosures – such as the Green Asset Ratio (GAR), which is intended to help capture what proportion of a bank’s assets are ‘green’ – there is still a long way to go to create and harmonise a reporting regime for the sector.  
 

Our view

Given the structural solidity of the European banking sector, our general preference is for European banks over their American counterparts. In the US there is greater dispersion, with idiosyncratic risk for banks that have specific issues, such as heightened exposure to urban office real estate, weak asset-liability management or a particularly concentrated deposit base.

Banks have such a large capital structure that they tend to be a capital structure play. We generally focus on the subordinated part of the capital structure, and continue to see value in AT1s at current levels – albeit with dispersion between names that have and haven’t recovered from fallout following the mini crisis earlier in the year. However, senior debt issuance from some of the smaller, less liquid issuers also offers pockets of value in the segment.
 

Erika Wranegard  Portfolio Manager

Our decarbonisation approach aims to build a diversified portfolio of higher yielding positions using credit and sustainability analysis to identify net-zero-aligned issuers in investment grade. How does our approach look in action?
 

Need to know: We use our proprietary implied temperature rise (ITR) metrics to identify borrowers that are aligned with the goals of the Paris Agreement. Such metrics add to our in-depth credit analysis and enhance our convictions In order to improve yields, we move further down the capital structure in preferred high quality issuers  We demonstrate our approach through case studies of Eni, Enel and Volkswagen5

 

A transition-focused approach

One aspect of our TargetNetZero fixed-income strategy is to select creditworthy decarbonisation leaders and invest further down the capital structure to improve yields.

Our transition-focussed approach seeks out companies with credible plans to decarbonise. Rather than being limited to low-carbon companies today, investing in the transition opens opportunities across all sectors of the economy, including high-emissions industries, thereby ensuring a more diversified portfolio. We believe the greatest positive impact on decarbonisation will come from companies that are currently high emitters that have the commercial need, financial resources and strategy to transition to lower emissions in the future. 

Decarbonisation metrics are part of our in-depth credit analysis and reinforce our assessment of an issuer’s creditworthiness. Meeting the goals of the Paris Agreement adds confidence to our analysts’ views that the issuer will be able to operate in a future low-carbon environment. To enhance potential returns, we move down the capital structure in preferred investment-grade (IG) issuers. 

Investing in hybrid bonds⁶ ensures the same level of IG default risk but offers returns⁷ in line with high yield. This approach aims to build a diversified portfolio of higher yielding positions than the corporate bond market index using credit analysis to choose net-zero-aligned issuers with IG senior ratings.
 

A snapshot of corporate ‘ice cubes’

Here, we provide a snapshot of three companies – Eni, Volkswagen and Enel⁵ – that our analysis identifies as ice cubes. These are companies in high-emitting sectors that are vital to economic activity and where cuts in emissions are most needed to reach a net-zero future. Crucially, although these leaders may have high carbon footprints today, they also have credible plans to decarbonise that are aligned with the Paris Agreement. 

We call these decarbonisation leaders ‘ice cubes’ as they contribute significantly to cooling the economy. On the other hand, companies with high emissions and insufficient decarbonisation plans are called ‘burning logs’. 

To identify ice cubes, we apply our in-house implied temperature rise (ITR) methodology to assign issuers a forward-looking temperature score. This measures how effective they will be in cooling their sectors, and the economy more broadly, in the future – and whether they will keep to the below 2.0°C warming threshold set by the Paris Agreement. Our ITR methodology has been independently reviewed by the TCFD’s Portfolio Alignment Team⁸ and the University of Oxford.

Ice cubes are the exception rather than the norm, and there are not enough in our universe to fill a diversified portfolio. In high-emitting sectors, we prioritise ice cubes whose decarbonisation potential could be mispriced and generally exclude burning logs. We also invest in low-emitting sectors where a higher ITR will have less impact on emissions but will add diversification.

Case studies⁵
 

Eni: outperforming in oil and gas Eni is a global leader in producing oil and gas, and a major refiner and transporter of oil and gas products in Europe. It has a credit rating of A-9. The oil and gas sector is responsible, directly or indirectly, for an estimated 42% of global carbon emissions10, making the decarbonisation of energy companies critical. However, this is a hard-to-abate sector where few companies are on a Paris-aligned temperature trajectory.  Using our ITR metric, we estimate Eni’s temperature score at 1.96°C11, in line with Paris Agreement goals. Its score has evolved positively in the last few years, falling from 2.5°C in 2021. Eni’s score is also below the oil and gas sector’s average of 4.0°C12, which means Eni is a sector leader.  A commitment to reducing emissions The temperature score reflects effective targets announced by the company to reduce its scope 1, 2 and 3 emissions13. Eni was among the first, and remains one of the few companies to report all scope emissions. To meet its objective to be net zero across all scopes by 2050, Eni is committed to reducing its emissions, compared to 2018, by: 32% by 2030 51% by 2035 73% by 2040 To reach its energy-transition goals, Eni has committed to spending EUR 13.8 billion between 2023 to 2026 on reducing its scope 1, 2 and 3 emissions  in existing operations.

Enel: reducing power emissions Active in more than 30 countries, Enel is one of the largest power companies by revenue globally. Its commitment to sustainability dates to 2004, when it joined the United Nations Global Compact, a voluntary initiative based on CEO commitments to implement universal sustainability principles.  Over the last decade, the BBB+ rated15 company has transformed itself from a predominantly coal-fired, power-generating utility to a business based primarily on renewables. Enel’s decarbonisation trajectory is all the more important since it operates in an industry whose progress on decarbonisation is essential to the climate transition.  Reaching net zero in 2040 At 2.01°C, its temperature score is aligned with the Paris Agreement16, making it an ice cube. Moreover, Enel’s temperature score has been very stable since 2021, ranging between 1.71°C and 2.10°C. The score reflects a number of targets announced by the company to reduce its emissions. Overall, Enel has pledged to reach zero GHG emissions across the value chain by 2040. Compared to 2017, Enel has committed to: decreasing its scope 1 emissions from power generation by 80% per kWh by 2030, and by 100% by 2040 cutting scope 1 and 3 GHG emissions from fuel and energy related activities covering all sold electricity by 78% per kWH by 2030 and by 100% in 2040 lowering absolute scope 3 GHG emissions from the use of sold products by 55% by 2030 and by 100% in 2040 reducing absolute scope 1 and 2 non-power generation emissions and scope 3 GHG emissions covering purchased goods and services, capital goods and all remaining fuel and energy related activity by 55% by 2030 and by 90% in 2040 These objectives are accompanied by a complete phase-out of coal planned for 2027. The company has the highest SBTi score17  possible, a first-decile ESG score and high social and governance scores, enhancing its credibility. Given the objectives already achieved and the credible medium-term indicators, which are SBTi validated, our confidence in Enel’s ability to achieve its objectives is very high.

 

Volkswagen: driving the transition to electric vehicles Volkswagen AG is one of the world’s leading auto manufacturers in terms of volume, brands and technology platforms. Solid cash flows from its internal combustion engine (ICE) business is funding the transition to electric vehicles (EVs), alongside various forms of financing such as green bonds under its Green Finance Framework. Using our ITR metric, we estimate Volkswagen’s temperature score at 2.15°C18. Taking into account Volkswagen’s reduction commitments, we assess the company to be nearly aligned to the Paris Agreement and consider it an ice cube. The company is also significantly better aligned than the average of the automobile sector of 3.4°C. Keeping to a range of 2.02°C to 2.15°C over the past few years, the company’s score has been extremely stable. Compared to 2018, Volkswagen has committed to: reduce absolute scope 1 and 2 emissions by 50.4% by 2030 reduce scope 3 emissions from the use of sold products of light duty vehicles by 30% per vehicle km by 2030  To meet the below 2°C target set by the Paris Agreement, Volkswagen’s entire vehicle fleet must become CO2-neutral by 2050, meaning all vehicles sold from around 2040 onward must be CO2-neutral because it takes about ten years to renew the fleet.  It has set other sustainability and carbon-neutral goals including: By 2023, Volkswagen will have switched manufacturing sites in Europe to 100% renewable energy By 2030 it aims to reduce the carbon footprint per car by 30% over its entire lifecycle, in line with the Paris Agreement By 2030 its share of BEV (battery electric vehicle) sales are anticipated to rise to over 50% worldwide Volkswagen is committed to the Paris Climate Agreement and now pools all environmental measures under its ‘goTOzero’ mission statement. It aims to have climate-neutral global operations by 2050, at the latest.

Moving down the capital structure

We consider Eni, Enel and Volkswagen to have strong investment-grade credit profiles, a conviction reinforced by their status as ice cubes which gives us confidence that they will thrive in a low-carbon world. As such, we choose to invest in hybrid bonds rather than senior bonds due to the more attractive reward profile. As hybrids sit further down the capital structure than senior debt, hybrids have slightly lower credit ratings than senior debt but the same probability of default, which is compensated with a material pickup in yield as can be seen in figure 1.
 

FIG 1. Spreads of hybrid bonds vs senior bonds

Source: Bloomberg as at October 2023. YtM refers to yield to maturity. YtC refers to yield to call. Govt refers to the Bund. Yields are subject to change and can vary over time.

 

Low carbon for positive trends

Climate-aligned fixed-income portfolios are well-positioned to capture the opportunities in the transition to a low-carbon economy. We believe that ice cubes could enjoy more favourable funding conditions when refinancing, a reduced risk of stranded assets and tighter credit spreads reflecting the additional creditworthiness from their sustainability metrics. Investing in net-zero-aligned issuers through our TargetNetZero strategy enables investors to tap into these positive trends.

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

 

Need to know: A key concern for fixed income investors at this stage of the cycle is how higher yields will impact corporates that are compelled to refinance their debts due to front-end heavy maturity profiles This issue should be idiosyncratic, with the lowest rungs of high yield and single B-rated euro issuers the most vulnerable because of their weak starting fundamental position  Dispersion in spreads is likely to increase disproportionately compared with aggregate spread levels, driving high potential for alpha generation for active investors via relative value

 

Why rising maturity walls will drive dispersion

A focal narrative in credit markets in the later stages of this cycle has concerned the impact the sharp rise in yields will have on corporates as they are forced to refinance front-end heavy maturity profiles in the coming years. Whilst we view this as an important consideration, the key question to address is how much debt serviceability – and consequently, default expectations – will be impacted, and whether current spread levels sufficiently reflect the implied risks. In this piece we posit that the refinancing wall does not pose an immediate threat at a systemic level, but that it will create idiosyncratic cases among the lowest-rated issuers, thus pushing dispersion higher.
 

The maturity wall in context

First, let us take a step back and assess the size of the maturity wall from a historical standpoint. As Figure 1 shows, the absolute amount maturing in the coming three years¹⁹ is certainly elevated by historical standards, both in investment grade and crossover (bonds rated BBB and BB). On the other hand, levels are not unprecedented in recent cycles relative to the total amount outstanding. However, when looking at the lower end of high yield, (single B and below), the maturity profile is more concerning, with the percentage of the debt stack approaching maturity in the next three years having rocketed to levels substantially above those seen in the last 20 years.

FIG 1. Amount outstanding in bonds maturing over the next three years by rating (as percentage of total amount outstanding)

Source: LOIM Calculations, Bloomberg. Covers non-subordinated, non-financial corporates in Bloomberg indices. As at September 29, 2023. For illustrative purpose only.
 

While the maturity wall by itself is less daunting for higher-rated issuers, the heavier burden of refinancing this debt remains a potential issue across the board given the substantial rise in financing costs over the last two years. There are two key elements to measuring the likely impact of this: firstly, the current state of corporate balance sheets and their current debt servicing burdens; and secondly, the relative increase in their financing costs at the point of refinancing maturing debt.

Figure 2 shows that interest coverage – measured as interest expense/earnings before interest and taxes (EBIT) – is at historically healthy levels at present. The outlier is clearly lower-rated high yield, particularly in the euro-denominated segment, which is running at interest coverage levels far below historic levels.
 

FIG 2. Interest coverage z-scores for bonds by currency and rating bucket, as at September 29, 2023

Source: LOIM Calculations, Bloomberg. Interest coverage calculated as market value weighted average of Interest expense divided by EBIT. Z-score is calculated using monthly data from 2005-2023. For illustrative purpose only.

 

Forecasting the cost of refinancing

More important than the situation now, however, is how the maturing debt wall will impact these levels. Using the following assumptions, we can conduct analysis to generate a simple forecast of how the maturity profile will impact debt serviceability (interest coverage) over the next two years²⁰. 

• Current yields are representative of yields over the coming two years, so are the yields at which maturing debt will be refinanced
• The interest burden of maturing debt is equal to the average coupon rate of debt maturing in the next 24 months (expiring cost of debt)
• All other factors are held constant²¹ 
• If we take the percentage of debt maturing over the coming two years and multiply it by the factor of the new refinancing rate relative to the issuance rate of maturing debt, we can generate an estimate of the incremental interest burden that the maturity wall will cause. The results are shown in Figure 3.

The first point to observe is that the relative impact of refinancing is heavier in Europe, particularly for higher-rated entities. For these companies, which previously enjoyed near-zero funding costs, the relative increase is substantially higher.

This unearths an important distinction between European and US issuers; namely that while the absolute increase in the cost of capital is important, from a refinancing perspective, the absolute increase relative to the starting point is more impactful. This could be compensated for if the interest coverage were much lower in the region to begin with, but in fact European and US issuers currently have comparable fundamentals in this regard.

By historical standards, however, the most affected segments currently have healthy levels of interest coverage, so forecast levels are still above the lows seen in the previous cycle from 2010 to 2020. Yet again, the weak starting fundamental position of single B rated European issuers²² means they remain likely to be the real area of weakness through the impending shift to a higher cost of capital.
 

FIG 3. Current, forecasted and past minimum average interest coverage levels by rating
A: US    B: Europe

Source: LOIM calculations, Bloomberg. Forecasts are estimated using assumptions set out in the main text; they do not contain any analyst-based expectations and are for illustrative purposes only. Current levels as at September 30, 2023. For illustrative purpose only.

Ultimately, this suggests that the maturity wall itself does not pose a structural issue to markets²³. However, it is important to note that this analysis looks at aggregate levels and does not examine the underlying distribution of issuers within each rating bucket. We believe the maturity wall can influence performance on a more idiosyncratic basis; this would increase spread dispersion across issuers, providing fertile ground for relative value investing by active managers.

Taking a more bottom-up approach, we can analyse how many companies by rating bucket sit below the threshold of an interest coverage of 1.0, and how many, under the assumptions outlined previously, would sit below that threshold in two years (see Figure 4)²⁴. Again, the situation is more acute in the European market; however, it’s clear that across almost all rating buckets there are many issuers susceptible to the increased interest burden. With that in mind, a deeper understanding of the underlying fundamentals and maturity profiles on a company-by-company basis will be key to picking out those that have a robust enough profile to navigate the changing environment.
 

FIG 4. Percentage of universe with interest coverage levels below 1.0
A: US    B: Europe

 

Source: LOIM calculations, Bloomberg. Forecasts are estimated using assumptions set out in the main text; they do not contain any analyst-based expectations and are for illustrative purposes only. Current levels as at September 30, 2023. For illustrative purpose only.

 

Dispersion to return 

The initial move in spreads through 2022 was indiscriminate and structural. This is often the case with knee-jerk risk-off moves since selling is carried out at a blanket level as allocations reshuffle. Whilst this moves spreads higher, it does not necessarily translate into levels of dispersion that fairly reflect the diversion in potential future performance. 

In Figures 5 and 6, we plot spread dispersion per unit of spread level²⁵, which we use to gauge how indiscriminate markets are being in their pricing across the investible universe. In theory, a move higher in this metric should provide a prime opportunity for relative value investors to benefit and generate alpha. Figure 5 underlines the difference between the current dispersion picture in low-rated high yield versus crossover and investment grade. High yield currently exhibits high dispersion for the given level of spreads, but this is not the case in BB and higher-rated bonds, where dispersion is low relative to spread levels.

FIG 5. Spread dispersion per basis point of spread 
A: US  B: Europe

Source: LOIM calculations, Bloomberg. As at September 30, 2023.

 

FIG 6. Spread dispersion per basis point of spread (z-score – January 2009-Sepember 2023)

 
Source: LOIM calculations, Bloomberg. Z-scores calculated as at September 30, 2023; average and standard deviation used calculated using monthly data from January 2009 to September 2023. 

 

Conclusion

In summary, our analysis indicates that the impending maturity wall is a structural concern only for the lowest rated corporates in the US and B issuers and below in Europe. This would lead us to allocate towards higher-rated high yield and investment grade²⁶.  

That said, idiosyncrasies in spread pricings are likely to increase over the coming two years across all rating buckets, due to the range of sensitivities to the heightened cost of capital and broader tight financial conditions. As such, we would expect the dispersion to increase disproportionately more than aggregate spread levels themselves. This should drive high potential for alpha generation via relative value within corporate bond markets for active managers.

 

 

 

sources.

1  Source: Bloomberg, LOIM at October 2023.
2  Source: Panigirtzoglou, N. et al. “Flows & Liquidity: Why are Bond Markets Still Trading Long?” J.P. Morgan Global Markets Strategy, 28 September 2023. 
3  Assuming coupons are reinvested at the purchase yield of 2.38%.
4  Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
5  Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document. 
6Hybrid bonds are subordinated debt instruments which, in many cases, offer investment-grade default risk accompanied by high-yield returns.
7  Past performance is not an indicator of future returns. For illustrative purposes only. Yields are subject to change and can vary over time.
8  See Blood, D. and Levina, I. “Measuring Portfolio Alignment: Assessing the position of companies and portfolios on the path to net zero.” Published 2020.
9  Awards and ratings may vary without notice.
10  The future of oil and gas is now: How companies can decarbonize | McKinsey
11  Source: HolistiQ analysis as of October 2023. HolistiQ is a trading name of the Lombard Odier Investment Managers group (“LOIM”) and is not a legal partnership or other separate legal entity. Any dealings in respect of holistiQ shall be carried out solely through LOIM regulated entities and their authorised officers. Systemiq Limited is not a regulated entity and nothing in this website is intended to imply that Systemiq Limited will carry out regulated activity in any jurisdiction.
12  Source: HolistiQ analysis as of September 2023..
13  Scope 1 emissions comprise all those directly under the control of a company. Scope 2 emissions come from the generation of power, heat, steam and cooling a company buys. Scope 3 emissions include emissions linked to a company’s wider value chain. These emissions can be roughly divided into those linked to the company’s upstream supply chain and those linked to the downstream lifecycle of its products and services.
14  Source: Eni for 2022. A Just transition
15  Awards and credit ratings may vary without notice
16 Source: HolistiQ analysis as of October 2023.
17  SBTi stands for the Science Based Targets Initiative.
18  Source: HolistiQ analysis as of October 2023.
19  Note that we use time to maturity rather than average life to create the three-year maturity wall cut-off, while other research might use the latter. This is because we consider time to maturity to be a fair representation of unavoidable refinancing needs, whereas average life includes extendable debt, which may be extended rather than refinanced and hence could be viewed as a less pressing maturity. Please contact us for further detail on this topic if required.
20  The assumptions used are designed for conservativity and are not our base-case assumptions, so the outputs should not be taken as expected outcomes; this exercise is mainly intended to direct us towards which rating buckets in which regions are most susceptible to the new cost of capital, all else being equal.
21  Key assumptions under this condition: EBIT to stay flat over the two-year period; all debt rolled (no leverage consolidation); debt will be refinanced in line with current maturity profile.
22    We note that Telecom Italia (TITIM), which we calculate to have a particularly low interest coverage, has an outsized downward impact on the aggregate EUR B metric. However, even when excluding TITIM’s impact, current aggregate levels are slightly below the 2010-2020 local lows, highlighting that the weakness within the segment is wider than just one name. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
23 Under current conditions we do not expect the maturity wall itself to pose a systemic issue to markets, however it can act as an amplifier in the event of yields increasing rapidly at inopportune moments.
24 We shock interest expense for each ticker by the expected refinancing increase factor based on its given rating. All other assumptions are left as outlined above.
25  Formula: Standard deviation of spreads within rating bucket divided by average spread level for rating bucket.
26  In line with our Q2 Alphorum commentary, for valuation purposes we would continue to focus on the lower end of investment grade to access yields above cash, namely BBB’s. See “LINK TO PRIOR ALPHORUM PIECE” for more detail.