Monthly review and performance
Market sentiment remained weak in May, as spreads on EUR investment grade (IG) widened by slightly over 10 bps on the month to above 160 bps, as a result of macro concerns. Inflation prints continue to surprise to the upside, with both headline and core CPI in the Eurozone coming above expectations. The effects of rising inflation on the economy are already being felt, with consumer confidence dropping sharply in the EU and a squeeze in disposable incomes. Interest rates remained volatile, as a result of investors balancing the impact of more hawkish central banks and expectations of lower growth. Nevertheless, rates ended the month higher, with the 10-year Bund yield up close to 20 bps. The combined impact of further spread widening and rates moving up has weighed on performance, with the sell-off since last summer erasing more than five years of IG total returns.
Market activity picked up in May, with EUR 6 billion of green bonds from financials issued. As a sign of markets stabilising, we saw the issuance of green bonds in subordinated format. Munich Re, one of the leading reinsurers, issued a green Tier 2 in US dollars with a coupon of 5.875% (spread of roughly 300 bps) with a maturity in 2042 and first call date in 2032. The instrument is rated “A2” by Moody’s, and at a spread (at issuance) of around 300 bps, the spread pick-up to USD “A” rated IG corporates is above 150 bps. Despite the very attractive levels, we have not participated in the new deal as we prefer Munich Re’s equivalent EUR-denominated Tier 2s that screen more attractively and are slightly shorter dated. We continue to expect sustained issuance of green bonds from European financials, and therefore attractive opportunities in the primary market.
The Bank of England published the results of the climate stress test of the UK financial sector (banks and insurers). The output of the stress test has shown that the impact of the transition and physical risk scenarios are manageable.
Incremental aggregate credit losses for the banking sector for example over the 30-year horizon were in the range of circa GBP 50-100 billion (or circa GBP 1.5-3 billion per annum), which is highly manageable compared to annual pre-provisions profits of more than GBP 15 billion for HSBC alone. The most important take-away of the stress test is the regulatory and supervisory implications. Increased pressure on banks and insurers will lead to a strengthening of risk management capabilities, more robust disclosures and ultimately influence capital requirements.
We continue to see strong value in green bonds of European banks and insurers. With an average yield to worst of around 3.1% on the fund and around 230 bps of spread, we are capturing around 0.7% pick-up in yield compared to 2.4% on EUR IG corporate bonds. This is also achieved by taking less interest rate risk compared to the EUR IG index, with a 4.3 duration on the fund compared to around 5 on the index. We remain biased towards high quality issuers (BBB+ average bond rating). As an example of attractive opportunities in our market, ING’s 0.875% euro Tier 2 maturing in 2032 (callable in 2027) yields 3.7% and is rated BBB composite, which is more than 1% pick-up in spread and yield compared to the EUR IG corporate index.
Annual Impact Report
We are pleased to have published the first annual impact report of the fund. The report provides insight into the fund’s sustainability activities, including environmental impact, granular analysis of the proceeds of the green bonds, case studies, engagement activities as well as our overall framework to select issuers and green bonds.
The impact report can be accessed here: https://www.gam.com/-/media/content/featured-funds/gam-climate-bond-impact_report_202205_en_online.pdf