Market backdropÂ
After a very strong start to the month, fixed income markets gradually crept lower during the month as rates rose significantly in February, with EUR investment grade (IG) corporates ending the month -1.4% in terms of total return. Sentiment remained resilient nevertheless, as spreads were slightly tighter over the month – by 4 bps to 148bps. Rising rates were the key driver of returns over the month, as the 10-year Bund yield was up close to 40 bps on the month, with the shorter end of the curve seeing even sharper moves. Inflation and central banks remained in focus, as investors reassessed expectations of terminal rates on the back of inflation data and hawkish rhetoric from central banks. Higher rates volatility and weaker sentiment have been offset by continued inflows in IG credit over the month, supporting spreads that were tighter on the month.
Performance
The fund’s NAV during the quarter (Z class, EUR) decreased by 1.3%. Performance has been driven by the surge in rates (10-year Bund +36 bps in February), while spreads were slightly tighter. Moreover, the fund’s performance was driven by (1) the outperformance of financials versus corporates over the month by around 4 bps in spread terms (2) the underperformance of subordinated debt with spreads on euro IG Tier 2s and EUR Additional Tier 1s (AT1s) a couple of bps wider on the month. Over the month, negative contributors to performance were mainly Insurance Tier 2s, that typically have longer duration and spread duration and hence have been more impacted by rising rates. Moreover, bank senior and Tier 2s have also been impacted by higher rates. While most bonds have generated negative total returns in February, top performers for the month were a few shorter dated senior bonds that were less impacted, or positions exited earlier during the month.
Positionning
After a very heavy month of January, supply in financials’ green and sustainability bonds remained robust in February, with circa USD 5 billion issued over the month. This compares to USD 10 billion in January 2023 and circa USD 5 billion in February 2022. All deals came in senior format from banks, and while some came at decent levels, we did not participate, given the strong value in existing bonds, especially those in subordinated format. Over the month we increased the allocation to AT1 contingent convertibles (CoCos) and Tier 2s from insurers, with subordinated debt now circa 60% of the fund’s holdings. As an example of attractive subordinated bonds in the fund, BBVA’s 6% green AT1 CoCo callable in 2026 yields close to 8% yield to call (if not called the coupon resets to the EUR 5-year swap + 6.456, ~10% today), which is ~2% extra yield compared to BB-rated EUR corporate high yield, for a BB-rated bond of a A-rated issuer that was profitable during the Global Financial Crisis (GFC), European debt crisis (EZ) and Covid-19 crises. Duration has slightly increased over the month given the increased allocation to subordinated insurance bonds, to around 4.2 – although this remains below the duration of the EUR IG corporate market of 4.5.
Outlook
With a yield (to next call) of around 5.5% and an average spread (G-spread) of circa 260 bps on the fund (compared to 4.3% / circa 150 bps for the EUR IG corporate market), we see this as a unique opportunity to capture high income with upside potential from tightening spreads. This is despite the high–quality bias of the fund (average bond rating of BBB+ / average issuer rating of A) and lower duration compared to EUR IG corporates (4.2 versus 4.5). We believe European financials’subordinated debt are the sweet spot for bond investors, providing both solid fundamentals and attractive valuations. In the current environment banks benefit from higher earnings as rates rise, while insurers’ solvency ratios have seen a significant uplift from higher rates. Fourth quarter earnings remained in focus in February, with the majority of European banks and insurers now having reported full year results now. The majority of banks beat earnings expectations, as tailwinds from higher rates continue to boost net interest income. Capital positions remain strong, with most banks operating above their target solvency levels. Despite elevated macro uncertainty, asset quality remains robust, with stubbornly low non-performing loans (NPLs). While provisions for loan losses have increased somewhat, the impact is a fraction of the benefit from higher rates. As an example, BBVA reported a ~35% increase in revenues in Q4 compared to Q4 2021 as net interest income rose by close to 50%. While loan loss provisions role mildly, the group reported a EUR 0.3 billion rise (close to +20%) in quarterly profits over the year to EUR 1.6 billion in Q4. BBVA reported a return on tangible equity of 15.3% for 2022, above their previous target of 14% by 2024. The group’s Common Equity Tier 1(CET1) ratio was up to 12.8% (+0.35% over the quarter) – close to EUR 14 billion of excess capital, while NPLs continued to decline to 3.4% of loans (down from 4.1% in 2021). Thus illustrates the very supportive macro environment for financials.
Project features
- Project type: Waste-to-Energy Plant
- Location: Ireland
- Project owner: Munich Re (minority equity share)
- Total investment: ~€100m (amount allocated to green bond)
- Energy generation Capacity: 69MW, generating ~500,000MWh per annum
- Avoided CO2 emissions per annum: 112,000 tons
Additional details
- Facility has a dual role of waste disposal (non-recyclable waste) and generating energy from waste
- Supplies power for 100,000 households by burning ~600,000 tons of waste
- Recycling capacity of ~15,000 tons of material per annum
Munich Re’s sustainability strategy highlights
- Facility has a dual role of waste disposal (non-recyclable waste) and generating energy from waste
- Supplies power for 100,000 households by burning ~600,000 tons of waste
- Recycling capacity of ~15,000 tons of material per annum
