US investment grade credit suffered in Q1 2021 on the back of rising Treasury yields. Outright yields are now higher and spreads to government bonds a little wider, which should appeal to European investors in particular. Yield spreads to Euro credit are at multi-year highs on a currency-hedged basis. So an allocation to US credit makes sense but, to capitalise on where the flows are going, focus on ESG funds.
Investment grade (IG) credit was the darling of investors in 2020. Dramatically wider spreads to government bonds, following the March sell-off, coupled with a central bank backstop made IG credit an easy investment choice. However, the positive feelings toward the sector had largely played out by the end of the year. Rising US Treasury yields, the end to the Federal Reserve’s buying program and little room for further spread compression meant that Q1 2021 was a rough one for IG bonds with negative returns and net investor selling of the sector as US Treasury yields surged. Nevertheless, with every price reset comes an opportunity to reassess value and, in the case of US IG credit, we see reasons to be positive again.
Treasury yields now more stable. The rush to sell Treasuries and IG credit during the quarter (see the flows section of the Q2 2021 Bond Compass ) and reduce duration exposure has potentially left some investors underweight these exposures and short duration risk. With Treasury yields now looking more stable, there is an incentive to trim back these underweight positions. Indeed, with the economic and inflation data having surprised on the upside during recent months there is a fair amount of positive news priced by risk assets. This is logical: the economic reflation is expected to continue but it does mean that the risk-reward around fixed income assets now looks more symmetrical.
The price correction has created a more attractive yield. As we point out in Theme 1 in the latest Bond Compass, yields on an all maturities US IG credit fund are well above 2%. This is particularly appealing for EUR-based investors who can expect something closer to 30bp on a similar EUR exposure. Investing in US credit leaves investors exposed to currency risks and the USD is once again softening. However, the cost of hedging is historically low and, when incorporated into the equation, spreads of close to 100bp are at their most favourable to EUR-based investors since early 2017 (Figure 1).
There are some risks to US fixed income assets if inflation continues to exceed expectations but the spread compression between both US Treasuries and German Bunds hints that there has been a move by the investors to reduce EUR exposure and reach for higher-yielding US assets.
Figure 1: The Hedged Yield on US IG Credit and its Spread to EUR Credit
Greensleeves
Last week’s announcements on cutting carbon emissions by both the UK and US governments as they prepare for COP 26 in November are going to intensify the focus on climate and ESG themes. So for investors thinking about venturing into US IG Credit, it makes sense to consider an ESG exposure. As outlined in the Bond Compass, the notable trend in US credit flows for European investors over the last 12 months has been into ESG-based investment strategies.
A key issue for investors who are covering underweight positions in credit is that of benchmark tracking as many ESG strategies bear only a loose similarity to the wider bond exposures. For instance, the allocation to banking bonds in the Bloomberg Barclays US Corporate Index is 20.9% but the average for a basket of seven Bloomberg Barclays MSCI ESG indices is over 25%. The mis-alignment of sector weightings can cause tracking error.
The Bloomberg SASB US Corporate ESG Ex-Controversies Select Index screens out companies that derive sales from tobacco, weapons and thermal coal and also excludes those involved in controversies or that have violated the United Nations Global Compact. The index is then optimised to both maximise its ESG score and push its characteristics toward those of the parent index. This means sector weights are more closely aligned to the Bloomberg Barclays US Corporate Index, therefore limiting tracking difference. This provides a neat solution for investors seeking to switch holdings into ESG-compliant funds but at the same time remain close to the benchmark.
