Monthly Commentary – June 2022 Climate Bond

Monthly review and performance

Negative sentiment was persistent during June. Spreads on EUR investment grade (IG) corporates widened by a further 56 bps during the month – bringing total widening to 120 bps since the beginning of the year, with EUR IG spreads now sitting close to 220 bps. Stubbornly high inflation – for example Spanish CPI coming in at 10.2% versus consensus of 8.8% – reflects the challenging macro context. Expectations of hawkish central bank actions and fears of a recession have continued to weigh on sentiment. Interest rates have risen over the month, albeit in a highly volatile manner, with the 10-year German Bund rising by circa 20 bps to 1.3% after peaking at close to 1.8%. Total returns over the month have been negative once again, with now close to seven years of total returns wiped out in the last 12 months.

Market activity remained resilient despite challenging market conditions, with close to EUR 4 billion of new issuance over the month, lower than in May. Volatile markets have led to highly attractive new issues, with large new issue premiums at high spreads and yields. Subordinated debt was in focus, with both a new bank Additional Tier 1 (AT1) deal (the second green AT1 ever issued) and an insurance Tier 2. In a landmark moment for the green bond market, DeVolksbank, the Dutch mortgage bank, came to the market with a 7% perpetual green AT1 callable in 2027 (if not called coupon resets to the 5-year swap rate plus 5.325%) at a highly attractive yield and spread (more than 500 bps). Generali, one of the leading European insurers issued a 10-year bullet Tier 2 at a 5.8% coupon, or more than 300 bps of spread, for an IG rated bond (Baa2/BBB rated at Moody’s/Fitch). We believe this reflects the attractive valuations in green bonds, especially in subordinated format.

Ahead of second quarter results, fundamentals of European financials continue to be strong. As an example, the average common equity tier 1 (CET1) ratio of eurozone banks remained very strong as of Q1 at 15.2% compared to an estimated average requirement of circa 10% – equivalent to around EUR 450 billion of excess capital. Asset quality remains resilient, as non-performing loans (NPLs) continue to decline quarter after quarter, now standing at 1.9% on average – compared to 6.5% in December 2014. There is now only one eurozone country where NPLs are above 5% – Greece – where NPLs are “only” around 7% – as tails risks in peripheral countries have sharply receded. Given ongoing macro uncertainty, we see financials as a sweet spot for fixed income investors, now one of the most resilient sectors in our view. Even in a worst case stress scenario, banks are likely to be able to absorb high NPLs and loan loss provisions with earnings only, leaving excess capital unscathed. Pre-provision profits will also benefit from higher rates, for example HSBC’s net interest income would rise by USD 5.4 billion with 100 bps of rise in rates – meaning a higher ability to absorb loan losses in a stressed scenario.

Valuations have already priced in a very weak macro scenario, fully disconnected from fundamentals of financials that should remain strong even in a weak scenario. With a yield (to next call) of 4.4% and an average spread (G-spread) of circa 320 bps on the fund (compared to 3.1% / circa 220 bps for the index), 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 index (4.3 year versus 5 year).

Green Project in Focus: La banque postale