After 2022, an “annus horribilis” for many investors, we believe that bond repricing now offers many opportunities. With a yield of 3.75%[1], the investment grade credit market appears highly attractive. However, companies are being seriously tested by the rise in financing costs, a less buoyant economic environment, difficult labour markets, not to mention the demand for investments needed for a successful implementation of the energy transition, digitalisation, as well as to help resolve social challenges. The careful selection of issuers and integration of extra-financial criteria are key!
Historical compensation
Never in its history has investment grade credit performed as badly, with the ICE BofA Euro Corporates index[2] falling by 13.94%. Yields tightened from 0.60% at the beginning of January to 4.45% in mid-October and 3.75% currently[3], which we think bodes well for expected future yields. Indeed, historically, the correlation between the rate level and the future annualised return over 5 years has been 83%[4]. Perhaps fixed income will attract investors again. While risk premiums have compressed close to the historical averages of 1.40%[5] in recent weeks, the total return of 3.75% still offers attractive carry, in our view. We would have to go back 10 years to see similar levels. We believe fixed income is currently at fair valuation levels, particularly considering that recession seems to have been avoided and interest rate volatility is once again under control.
An economic slowdown but no shock
Indeed, the eurozone seems to be taking the lead thanks to tax support, joint efforts by companies and households and rather mild temperatures. Energy prices have fallen sharply and inflation has finally fallen for two consecutive months. Inflation is also falling in the United States, which is reducing the burden on consumers while the significant rise in rates seems, as expected, to be slowing growth. The re-opening of the Chinese economy, economic support plans and the robustness of the labour market confirm our scenario of a slowdown in the global economy rather than a sudden shock. Against this backdrop, corporate profit margins and cash flow generation are expected to decline. But corporate balance sheets are generally healthy, which should help companies to cope with the slowdown. It appears that only the most cyclical and most indebted companies will be the most affected. The default rate is expected to remain moderate, between 3% and 4% at the end of 2023[6] versus 2% at the end of 2022[7].
An abundant primary market
The rise in interest rates has so far had a limited impact on the cost of credit cost of investment grade issuers. Only 11% of total debt must be refinanced in 2023 at an average coupon of 4% versus 1.90% in 2021[8]. Companies have benefited for many years from low financing rates, taking advantage of this to extend the average maturity of their debt. The maturity wall is expected in 2025. However, the lull in sovereign yields in recent weeks has encouraged the reopening of the primary market with great fanfare. Investment grade financial companies issued no less than €80 billion of bond, including €11 billion in subordinated debt, 86% higher than the monthly historical average over the past 5 years[9]. Non-financial issuance accounted for €21 billion, twice as much as in the last few years. The premiums granted were highly attractive and the appetite for bonds was very present. The high yield primary market has also reopened after several months of drying up, and early redemptions are expected to resume. However, the situation remains complicated for very low-quality issuers. There are no heavy maturities in the short term, but refinancing needs will accelerate in 2024.
Rigorous selection process
While we believe 2023 offers real investment opportunities in the bond market with attractive yields, we are also convinced that return dispersion will increase. Financial health, operational performance and cash flow generation are key factors in the selection of issuers. Taking into account climate ambitions has also become essential - especially since the objectives of the Paris Agreement and those of the European Union’s carbon neutrality commitment are fast approaching their deadline. Policies are advocating a more sustainable economy to address global challenges, and financial regulation calls for greater transparency on the integration of extra-financial criteria into strategic decision-making. Even the European Central Bank has adopted ambitious decarbonisation targets in order to encourage changes in economic behaviour. It aims to assess the carbon footprint of its portfolio of corporate assets, to promote sustainable finance by buying more green bonds and to put pressure on banks that finance polluting activities.
Taking climate objectives into account
Climate assessment, at the heart of the central bank’s greening balance sheet, is an undeniable asset for sustainable strategies. As announced last October, the European Central Bank (ECB) will take into account the carbon footprint of issuers, as well as their environmental disclosure and, above all, their decarbonisation targets. The most ambitious issuers with the highest transparency will be favoured at the expense of poor performers. The climate score will also be used on the primary market in order to favour issuers with the best climate performances and to limit the maturity of lower-rated issuers’ bonds. As a result, dispersion will increase. According to our analysis, based on the information available on Bloomberg, if we exclude issuers with the lowest climate scores, the eligible universe of the CSPP (Corporate Sector Purchase Programme) would be reduced by 25%. Schnabel’s speech at the beginning of January[10] also opened the door to a possible acceleration in the greening of the asset portfolio. Green bonds seem to be favoured, given that since last October, 36% of new investments in the CSPP have been labelled green bonds, while the CSPP-eligible universe only accounts for 28% over the same period.
The Sustainable Corporate strategy, a big winner
In this context of high dispersion, the correlation between financial and extra-financial risk and the greening of the ECB’s portfolio, we believe it is particularly opportune for investors to position themselves in the sustainable credit segment, and to adopt a selective approach to issuers. Based on our expertise, we aim to hold 20% green bonds by 2025 and to achieve a carbon footprint 30% carbon footprint below our benchmark[11]. These objectives, aligned with the criteria defined by the ECB, are represented by a fund, Candriam Sustainable Bond Euro Corporate, which relies on the joint work of our credit and ESG analyst teams and Candriam’s Best in Universe approach. This fund is classified as Article 9 in accordance with the SFDR and has the Towards Sustainability, SRI and LuxFlag labels[12]. Its management approach combines qualitative conviction and the integration of specific and sectoral issues - all of which we believe are appropriate to the current environment.
All of our investment strategies involve risks, including the risk of capital loss. The main risks associated with Candriam Sustainable Bond Euro Corporate are:
- Risk of capital loss
- Credit risk
- Interest rate risk
- Risk related to derivative financial instruments
- Liquidity risk
- Risk related to ESG investment
Risk related to ESG investment. The non-financial goals presented in this document are based on assumptions issued by Candriam. These assumptions are based on Candriam’s ESG rating models, whose implementation requires access to various quantitative and qualitative data,
depending on the sector and the exact activities of a given company. Variations in the availability, quality and reliability of the data may therefore affect Candriam’s ESG ratings. For more information on ESG investment risk, please refer to the fund’s prospectus.
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