EUR Credit and PAB: A Match Made in Heaven?
Bonds are Back and Aligned with a Greener Future
- Fixed income is back in the picture and, in our view, one of the most compelling opportunities lies within Euro-denominated investment-grade credit, which is offering yields above 4%1 with limited volatility
- Investors looking to tap into this opportunity, and also respond to the climate emergency, should consider adding a PAB tilt to their exposure
- Climate-aligned ETFs can provide cost-efficient and diversified exposure to Euro-denominated investment-grade credit aligned with the Paris Agreement, in a single transaction
Significant flows into Corporate Bonds, confirming that “Bonds are Back”
Bonds are most definitely back in the picture and of the current fixed income opportunities available, we believe Euro-denominated investment-grade credit offers one of the most compelling risk/reward profiles.
Flows to this asset class have accelerated over the past few months (€5.7 billion YTD), supported by the positive performance of underlying exposures1. Spreads have also reverted to the levels seen at the end of Q1 2022, prior to the bond market sell-off.
Sources: Amundi ETF, Morningstar, data as at 14/04/2023.
Past performance is not a reliable indicator of future returns.
Fundamentals appear strong
Across Europe, the effects of higher policy rates are still feeding through to borrowing costs for businesses and households, and have already led to an erosion in lending and demand. Despite this, the impact on corporate credit, thus far, has been contained owing to limited refinancing needs and the high use of cash reserves built up over the Covid period. As the effects of higher rates continue to wend their way through the economy, though, a further deterioration in activity seems inevitable and we anticipate anaemic growth in Europe for this year and next.
That said, we believe that spread levels in the European corporate bond market have priced in a far bleaker-than-materialised outcome. Moreover, following last year’s sell-off, and a decade of low-to-negative interest rates, investment-grade corporate credit is exhibiting attractive valuations with yield levels comfortably above 4%1. Investment-grade credit companies will be more likely to withstand a tougher environment ahead owing to strong fundamentals. Many have even been able to increase their profit margins in the face of increased production costs.
Even in the face of the recent market turmoil, investment-grade credit quality has continued to improve with rating upgrades for EUR corporates beating downgrades for a fifth consecutive quarter.
This is in contrast to EUR high yield corporates universe where the ratio of corporate upgrades to downgrades reached its lowest level in Q1 2023 since 2020. In our view, generally higher funding costs, sluggish growth and labour costs should result in higher default rates in the high yield debt space, which we anticipate rising closer to 4% by the end of the year.
Marrying Fixed Income with the Paris Agreement
With climate change widely recognised as a clear and present threat to the planet, ever more investors are seeking to align their portfolios with the net zero goals of the Paris agreement.
So how can investors tap into the potential opportunity in Euro-denominated investment-grade credit, while responding to the climate emergency?
An increasingly popular route is via climate-aligned indices, which help investors to meet their climate objectives by tilting exposures towards constituents with better climate profiles.
Tracking Climate Aligned Benchmarks – the background
In 2019, the European Commission unveiled two benchmarks that comply with the Paris Agreement – supporting the transition to a Net-Zero world by 2050 and limiting a global average temperature rise of 1.5°C; the Climate Transition Benchmark (CTB) and the Paris-aligned Benchmark (PAB). Major index providers, quick to recognise the opportunity, responded by launching a range of climate indices complying with these benchmarks’ requirements.
Both CTB and PAB focus on a decarbonisation level of at least 7% on average per year, but PAB indices aim to reduce carbon intensity by 50%, compared to the initial investment universe, versus 30% for CTB indices. PAB indices also apply some exclusion filters on companies involved in fossil fuel exploration and coal.
PAB is thus slightly stricter with regards to its thresholds, and may therefore be more suitable for investors who want to be at the forefront of the energy transition.
Both benchmarks have been widely embraced by the sustainable finance community, and a growing number of asset managers and asset owners are incorporating PAB into their investment strategies.
Looking ahead, it’s worth considering the potential consequences of the ECB’s decision to account for climate change in its monetary policy operations by skewing future corporate bond purchases towards companies that emit less carbon. Though the ECB will only select eligible bonds, redemptions could prove greater in sectors perceived as negatively affecting climate change to the benefit of greener alternatives.
Investment-grade credit and the net zero trajectory: Capturing the opportunity
Combining investment-grade credit with a PAB benchmark can bridge the gap between having a core credit allocation with solid fundamentals and an enhanced ESG profile: the Bloomberg MSCI EUR Corporate PAB Green Tilted Index ties it all in.
The table below shows the very limited tracking error between a PAB titled corporate bond index compared to an unfiltered investment universe. At the same time, the PAB corporate bond index allows for an improved ESG score and much lower carbon intensity. Performance is also broadly comparable.
Bonds are offering attractive yields once again, and in our view, the case for Euro-denominated Investment Grade Credit is currently compelling. Investors wishing to tap into this opportunity, but also respond to the climate emergency may wish to consider using a PAB approach. PAB indices help investors to implement net-zero strategies in their portfolios by tilting exposures towards constituents with better climate profiles. This can result in improved ESG scores and a far lower carbon intensity without affecting performance. By investing in ETFs aligned to a PAB benchmark, investors can be assured that their investments are benchmarked against a standard that aligns with the Paris Agreement's goals.
ETF implementation idea for consideration
AMUNDI EUR CORPORATE BOND CLIMATE NET ZERO AMBITION PAB UCITS ETF ACC
Management fees: 0.14%*
*Management fees refer to the management fees and other administrative or operating costs of the fund. For more information about all the costs of investing in the fund, please refer to its Key Information Document (KID).
1. Sources: Amundi ETF, Bloomberg, data as at 17/04/2023. Past performance is not a reliable indicator of future returns
Information on Amundi’s responsible investing can be found on amundietf.com and amundi.com. The investment decision must take into account all the characteristics and objectives of the Fund, as described in the relevant Prospectus
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