Monthly Commentary – October 2022 Climate Bond

Monthly review and performance 

Market sentiment improved in October, following very weak markets in August and September. In the EUR investment grade (IG) market, spreads were only marginally tighter on month (4 bps tighter to 221 bps) while subordinated debt outperformed sharply with IG-rated EUR Tier 2s around 25 bps tighter and EUR additional tier 1 contingent convertible bonds (AT1 CoCos) spreads close to 80 bps tighter. Rates also showed signs of stabilisation, as the 10-year Bund was roughly unchanged on the month at 2.1% – albeit with a circa 55 bps range during the month. Sentiment materially improved during the second half of the month driven by positive news in the UK with the appointment of Rishi Sunak as Prime Minister and more dovish comments from the European Central Bank (ECB). Dispersion in total returns were high, as EUR IG was roughly flat, while EUR IG Tier 2s were +1.1% and EUR AT1s +5.8% on the month.

Supply was limited during the month, with ‘only’ EUR 1.8 billion over the month, compared to EUR 2 billion in October 2021 and EUR 5.5 billion in September. Low supply was driven by issuers being in black-out ahead of the third quarter earnings season that kicked off in late October. Earnings have been very strong so far, as the tailwind from rates has far outweighed the increase in provisions due to macro uncertainty. As an example, Barclays deliver a GBP 1.5 billion net profit (12.5% return on tangible equity) for the quarter as net interest income was up GBP 1.1 billion year-on-year (each 25 bps rise in rates has a GBP 0.2 billion positive impact on net interest income (NII) in year one, GBP 0.5 billion by year three), more than offsetting normalising revenues in the corporate and investment bank (CIB) and higher provisions for loan losses (reflects UK macro uncertainty). Capital remained strong as the bank’s common equity tier 1 (CET1) ratio was up on the quarter to 13.8% – roughly GBP 10 billion excess capital. The bank is expected to make close to GBP 10 billion of pre-provision profits in 2023, which compares to GBP 4.8 billion of loan loss provisions booked in 2020 during Covid-19 and GBP 7.4 billion at the peak of the global financial crisis (GFC). This means that even in a GFC-style scenario increased loan loss provisions would be covered by earnings only, leaving excess capital unscathed. 

In our view, valuations remain attractive, fully disconnected from fundamentals of financials that would remain strong even in a weak macro scenario – as demonstrated by third quarter results. We have tactically added to several attractive areas over the month, for example we increased the exposure to AT1 CoCos to 9.3% from 8.1%, by adding BBVA’s 6% green bond at a 10.7% yield to call and 10% yield to perpetuity. Moreover, we have tactically added to some insurance Tier 2 bonds such as the 6.25% Macif 2033 bullet Tier 2s at a 7.5% yield to capture the opportunity from dislocated valuations (spreads above 500 bps on a BBB+ rated bond) and increased duration (by close to 0.2y) as the 10-year Bund neared 2.5%.

With a yield (to next call) of around 5.8% and an average spread (G-spread) of circa 350 bps on the fund (compared to 4.3% / circa 220 bps for the EUR IG corporate market), we see this as an 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 (4.3y versus 4.5y). 

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