Monthly Commentary – September 2022 Climate Bond

Monthly review and performance

Sentiment was weak in September, with a notable risk-off environment towards the end of the month. Spreads on EUR investment grade (IG) credit widened by 23 bps to 225 bps on the month, the widest levels year to date – approaching Covid-19 levels of 247 bps. The tone from central banks continued to be hawkish, as major central banks delivered large rate hikes combined with a firm commitment to tackle elevated inflation. The last week of the month was eventful, with negative headlines on gas supply in Europe and unexpected large fiscal stimulus in the UK, with the latter resulting in high volatility in UK and sterling assets. Interest rates continued their march higher, as the 10-year bund yield rose by more than 50 bps on the month to 2.1% – the highest level in the past 10 years. Total returns were in red over the month as EUR IG returned -3.3% in September, bringing year-to-date total returns to -14.6%. To illustrate the magnitude of the bond sell-off, the trailing 12-month total return of -15% as of September-end is by far the worst on record and compares to -6.7% at the worst of the global financial crisis (GFC).

Supply in financials’ green bonds was relatively resilient, despite seasonally high issuance in August as issuers frontloaded needs for the rest of the year. EUR 5.5 billion in September compares to EUR 7.2 billion of supply in August and EUR 5.2 billion in September 2021, albeit the majority was biased towards Nordic issuers in senior format reflecting challenging market conditions. The only notable deal in subordinated format was Abeille Vie (part of Aema group, one of the large mutual insurers in France), a 10-year sustainability Tier 2. The bond came at 6.25%, or a spread of around 478 bps to government bond yields. The bond is IG-rated by S&P at BBB+, and offers more than double the spread and circa 2.5% extra yield of yield compared to EUR IG corporates of similar duration/rating.

In our view, valuations remain attractive, fully disconnected from fundamentals of financials that we believe would remain strong even in a weak scenario – as demonstrated by second quarter results. European financials are a sweet spot for bond investors, providing both solid fundamentals and attractive valuations, in our view. In the current environment banks benefit from higher earnings as rates rise, while insurers’ solvency ratio has seen significant uplift from higher rates. This means that bondholders benefit from stronger fundamentals, that would remain extremely resilient even in a stressed scenario. As an example, BBVA was profitable during the GFC, eurozone crisis and Covid-19 crisis – recording its lowest annual profit since 2005 of EUR 2.1 billion in 2020 – demonstrating a strong capacity generate profits even in stressed environments. The group’s 6% Green Additional Tier 1 (AT1) in euros offers a yield to call of 11%, and if not called in 2026 the coupon would reset to the 5-year swap rate + 6.456% (roughly 9.6% based on month-end levels), a yield to perpetuity of 10.2%. Investors are capturing yields that are circa 2% above euro high yield bonds and 6.5-7% above BBVA’s senior bonds; in a A- rated bank that was profitable during the past crises.

With a yield (to next call) of 5.7% and an average spread (G-spread) of circa 360 bps on the fund (compared to 4.2% / circa 225 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 (4.1 years versus 4.6 years).

Project corner : Société générale