Monthly Commentary – July 2022 Climate Bond

Monthly review and performance

Sentiment improved significantly in July, with the second half of 2022 starting on a strong footing. Spreads on EUR investment grade (IG) corporates tightened by around 30 bps over the month to around 190 bps, reversing a quarter of the first half’s widening. Better sentiment has been driven by strong second quarter earnings and more dovish expectations for central banks (eurozone market implied policy rate in 12 months down from a peak of 2.5% in June to around 1% at the end of July). Nevertheless, the macro environment remains highly uncertain, as inflation continues to be high and above expectations (eurozone headline inflation read at 8.9% year-on-year for July), geopolitical risks around gas supply in Europe remain elevated, and we are seeing early signs of downside risks to growth from central bank tightening as US GDP contracted in Q2 (quarter-on-quarter). Government bonds have rallied over July, with the 10-year Bund yield down around 50 bps to 0.8% having retraced around half of the range in the first half (peak of 1.8% in June). The EUR IG corporates returned 4.7% on the month, from the combined effect of tighter spreads and lower rates.

Market activity was roughly non-existent, driven by upcoming earnings releases (issuers in black-out) and market conditions were relatively unfavourable for issuers as spreads remain very wide. In the European financials green bond space only one deal priced in senior preferred format. Supply for July totalled EUR 0.4 billion, compared to EUR 4 billion in June and seasonally low compared to EUR 2-2.5 billion in July 2020/2021. Total supply in 2022 now stands at around EUR 25 billion compared to EUR 31 billion at the same time last year, below our expectations but resilient in a challenging market. We expect banks and insurers to be active in the green bond market, and issuance is expected to remain high – which will increase our opportunity set and lead to attractive new issues.

Second quarter results have been strong, as banks and insurers continue to demonstrate their strong fundamentals. Standard Chartered for example reported a 9.9% return on tangible equity for the first half of the year as net interest income was up 13% year-on-year (adjusted net interest margin up 13 bps to 1.32%) boosted by higher interest rates. Asset quality remained strong as loan loss provisions were very low at 0.18% of loans (annualised) below 30-35 bps medium-term range and non-performing loans down compared to end-2021 to 2.7%. Capital remained strong with a common equity tier 1 (CET1) ratio of 13.9% or USD 9 billion of excess capital to protect bondholders. Higher interest rates will continue to feed through earnings, which are expected to translate into circa 15%+ growth in net interest income in 2022 and 2023, roughly a uplift of 4% plus on return on tangible equity in 2023 compared to 2021. On the insurance side, CNP reported strong results, with a Solvency II ratio up 32 percentage points on the first half of the year to 249% (requirement of 100%) driven by the direct positive impact of higher interest rates, with excess capital now standing at EUR 24 billion.

Valuations remain attractive in our view and fully disconnected from fundamentals of financials that we believe will remain strong even in a weak scenario – as demonstrated by second quarter results. With a yield (to next call) of 3.7% and an average spread (G-spread) of circa 290 bps on the fund (compared to 2.4% / circa 190 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 the EUR IG corporates (4.2 years versus 4.8 years). 

Project corner : AXA