Invesco: Increasing investment grade credit exposure: a conversation with Invesco experts

The attractiveness of IG credit in 2023

Kate Dwyer: Mike, 2022 was a year unlike any other. How are you feeling about the outlook going forward?

Mike Matthews: Yes, indeed, 2022 was the worst year for investment grade credit since most indices began and will represent the first time that we have seen two consecutive years with negative returns. But, after a painful repricing of markets as central banks fought to tame inflation, we’re entering 2023 feeling much more optimistic about prospects for the asset class – a sentiment that I know is echoed by Lyndon and Paul too.

Lyndon Man: Yes, absolutely. After last year’s extreme selloff, the silver lining is that yields and valuations look more attractive than they have in a long time. For investors who want to lock in an attractive income stream in real terms, it’s no longer necessary to reach for more volatile asset classes like equities. In other words, the “income” in “fixed income” is back. 

Kate Dwyer: Thanks Lyndon. Yes, that’s been a really interesting turnaround. We’ve gone from an environment where investors were migrating to equities and illiquids to meet their goals to one where global IG is actually generating more income than the dividend yield on global equities.[1] Paul, I alluded to industry flows briefly earlier, but perhaps you can talk a little more about that. Are we seeing the impact of this change in the data?

Paul Syms: Yes, I would say we are. Flows into fixed income ETFs picked up in the second half of 2022 following the rise in yields. Overall, the fourth quarter was the strongest for fixed income ETF inflows, with $11.9 billion in net new assets. This accounted for over 40% of total net inflows for the year. And while government bonds were favoured earlier in the year, investment grade credit was the leading category in the fourth quarter, taking over 60% of net fixed income ETF inflows.

Figure 1. Q4 fixed income ETF flows by theme

Source: Invesco

Kate Dwyer: And does that mark the start of a turnaround, would you say? As you know, we saw strong inflows into government bond ETFs in 2022 as yields rose. Is a preference for credit now taking over?

Paul Syms: Good question. Look, with recession on the cards this year, government bonds would generally be expected to fare well. But, yes, going forward, we do think 2023 could be the year for credit – and this has already started to show up in the flow data. But I think there are two key triggers that would cause a further switch in investor preference from government to corporate debt, and we will be watching these closely. Firstly, central banks pivoting from fighting inflation to promoting growth. Secondly, credit spreads widening to levels that adequately compensate for the additional risk.

Kate Dwyer: And Paul, is the market giving any indication of when these two things might happen? The US Federal Reserve pivot in particular has been a hot topic of conversation for clients and investors.

Paul Syms: Well, as far as the first point is concerned, we do not know exactly when the Fed will pivot from raising interest rates, but it’s likely to be driven by inflation, so any sign of improvement there could trigger a shift in investors’ risk appetite.
 

The monetary policy outlook: what does it mean for IG credit?

Kate Dwyer: Before even getting to the monetary policy segment of our discussion, we’ve touched on inflation, interest rates and the timing of a Fed pivot. And frankly, it’s difficult not to, because the outlook for fixed income is so inextricably bound up with the monetary policy outlook. Lyndon, Paul mentioned that signs of inflation slowing or coming down are the key things to look out for. Are you seeing any of these signs just yet?

Lyndon Man: Well, it’s certainly too early for central banks to declare victory over inflation. But initial signs do suggest a topping out in the short term, and longer-term indicators have also moderated. This would put the authorities in a more comfortable position in 2023, with a diminishing need for further rate hikes. And I would say that recent comments from a number of central banks support this.

Kate Dwyer: Thanks Lyndon. And Mike, that’s something I’d be keen to get your thoughts on as well. Are you and Lyndon in a similar place in terms of your views right now?

Mike Matthews: Yes, I’d agree with the point about it being too early for central banks to declare a win. 2023 has begun with inflation still high, and I don’t think central banks have finished raising interest rates just yet. That said, like Lyndon, the team and I do believe that inflation in the US and the UK has probably peaked. In terms of what this means for markets? Well, I think they may begin to forecast declining rates 12-18 months out.

Kate Dwyer: Thanks Mike. So, I’ve spoken fairly extensively about the fact that we’re observing opportunity in the IG credit space, and Paul has highlighted a Fed pivot as an important turning point in catalysing that further. Lyndon, can you just elaborate on that a little more.

Lyndon Man: Sure. So, as Paul has suggested, credit markets stand to gain from central banks relenting on their tightening stance. We have seen spreads move considerably wider in 2022 on recession fears, and they are now comfortably above long-term averages. They could be expected to retrace this move as the global economy troughs and eventually returns to a growth path. 

In this case, with valuations wide and inflation expected to moderate, corporate bonds look attractive to us on a medium to long-term view. Even if government rates and/or spread levels remain unchanged or leak slightly wider from here, the levels of income (“carry”) provide a substantial buffer to total returns with the global corporate index currently yielding around 5% in local currency terms.

IG credit: risks, economic challenges and recession

Kate Dwyer: Lyndon, you have touched on credit spread widening and recession fears. Now, on the one hand, widening spreads create income opportunity. But they also indicate additional risk. We’re hearing talk of slowing growth and recession, for example. What does this mean for IG credit? Mike, perhaps you can start.

Mike Matthews: That’s right, investment grade spreads have widened from very low levels and, outside of crisis periods such as the GFC, have rarely been wider than they are today. In part this reflects the end of QE and an aggressive rate hiking cycle. But it also reflects the more challenging economic background.

What’s exciting, though, is that the yields available on investment grade bonds are now higher than they were on high yield bonds at the start of 2022. Furthermore, we’re able to generate this without exposing the portfolios to too much credit risk. Unlike in other crises, the banking system remains secure and well-capitalised and corporates are not overleveraged. The risks this time are not systemic, and that gives us confidence to buy corporate bonds.

Kate Dwyer: Thanks Mike. Now, Paul, you’re an ETF man. And in our role as a passive provider, what’s important is providing a menu of index exposures that clients can select from based on their objectives, preferences and risk appetite. For clients who are thinking about taking an exposure to investment grade corporate bonds right now, is Mike’s outlook something you would echo?

Paul Syms: Yes, I would broadly agree with Mike’s sentiment. The risk-free rate is currently at decade highs, meaning that credit is now generating a yield that offers some protection against downgrade and default risk. Even if investors do expect an economic downturn in 2023, barring a deep recession, the current levels of yield available on both investment grade and high yield bonds look reasonably attractive.

Kate Dwyer: On the topic of high yield – as I think that’s something clients will want to delve into a little further – how attractive is that looking relative to investment grade? If clients want to increase their credit risk exposure, where should they be focusing their attention?

Mike Matthews: As far as our portfolios are concerned, we currently favour investment grade over high yield. And there are several key reasons for this. We are in an energy crisis and a wider cost-of-living crisis. What’s more, inflation is still high. None of these factors are good for consumers and economic growth.

On top of this, we are either in or about to enter a recession in the UK and in other countries too. For corporate bonds, and especially high yield bonds, there could still be some areas of concern over the next few quarters.

That said, unlike at the start of 2022, we now feel there is plenty of opportunity too. And, as I mentioned earlier in our discussion, we feel the balance of yield to risk in the investment grade market is more attractive than it has been for a long time.

Kate Dwyer: Thanks Mike. You’ve covered some potential areas of risk given the economic outlook, and I wonder if that’s something you can touch on a little more, Lyndon? Despite the fact that companies have entered this period with reasonable balance sheet strength, I know that clients will be interested in your views on what the default and downgrade environment looks like.

Lyndon Man: Thanks Kate. So the good news is that defaults are very rare for investment grade issuers, as Figure 2 shows. Even in 2008-9, this peaked at only 0.3-0.4% of the universe. The threat of downgrades though, as you have alluded to, is more relevant for the sector.

We have just enjoyed a positive bounce in rating migrations post Covid, but could see an increased number of negative actions in 2023 as growth slows. Given balance sheet and earnings strength, though, a severe wave of fallen angels is not our base case.

Figures 2 and 3. Global default rates (investment grade versus speculative grade) and annual rating actions

Figure 2 and 3 sources: S&P Global Ratings Research and S&P Global Market Intellegence's CreditPro®. Copyright 2022 by Standard & Poor's Financial Services LLC. All rights reserved.
*Excludes downgrades to D.

Historical case studies: some similarities and differences

Kate Dwyer: The word “unprecedented” has been invoked left, right and centre over the last three years, so I’m reluctant to use it. But in conversations with investors, clients and market strategists, the sense we’re getting is that we really are sailing in unfamiliar waters right now.

Paul Syms: Yes, I think “unprecedented” is right. Off the back of a pandemic, we’re now living through a major land war in Europe. Consumers and businesses alike are being hit by soaring energy costs, which have only added to existing inflationary pressures. Then there have been more localised crises too – take the political melodrama and gilt market crisis we’ve just experienced in the UK. 

Kate Dwyer: Exactly right. And the sense I’m getting from clients is that, what they’re looking for in a provider like us is some guidance as they navigate this challenging period. So Mike, it’s probably a tricky question, but can you highlight any historical periods that resemble the environment we’re experiencing today?

Mike Matthews: Well, Kate, it’s certainly an interesting question. But I would say that the current market conditions are actually quite different to other periods of elevated yields and spreads we have seen over the past 30 years. During periods like the TMT bubble, the global financial crisis, the eurozone crisis and the Covid pandemic, it was clear that global central banks were there to offer support. Meanwhile, today, central banks are hiking rates to tame inflation.

A second key difference, though – and one that investors should take comfort from – is the point I introduced previously. And that’s the fact that the risks this time are not systemic. Banks and corporates are not where they were in 2008.

Kate Dwyer: Thanks Mike, that’s interesting. So, there aren’t any perfect case studies but, in some ways, we should be relieved by that! Lyndon, what are your thoughts?

Lyndon Man: I would agree with Mike that direct comparisons aren’t perfect. That said, 1994 has been cited as a comparison to the present-day scenario a few times, and I think it’s an interesting one to consider. That year, the Fed hiked rates from 3% to 6% within a year in an effort to cool an overheating economy. Interest rates then dropped slightly, but stayed above 5% until 1998.

In terms of the impact this had on corporate bonds? Well, the US corporate bond market experienced a sharp drawdown of nearly 7% from January to June 1994, but then started on a recovery path through 1995.

By comparison, the drawdown in 2022 has been much more severe, with corporate bonds down 15-20%.

Kate Dwyer: And would you say the severity of the drawdown this time is the main difference between the two periods?

Lyndon Man: Yes, partly. It’s also worth noting that inflation rates were much more moderate then at 3%, compared to the 7% rate we’re experiencing today. Also, there was no recession in 1995, while many expect one in 2023 as the full impact of the monetary tightening hits.

In the three decades since then, though, the corporate bond investment landscape has also evolved substantially. Thirty years of secularly declining rates encouraged the US market to grow from c. $0.6 trillion par value in 1994 to $6.6 trillion today!

Likewise, the advent of the Euro has fostered a global approach to investing in credit thanks to market consolidation. You can now pick and choose more flexibly across markets and even exploit anomalies within the same issuer, so it’s possible to migrate to areas where conditions look more favourable.
 

Portfolio positioning: where we’re seeing opportunities right now

Kate Dwyer: So far, we have spoken a lot about opportunity that the market is creating, but I’d like to get a little more granular and focus in on what’s going on in the portfolios you manage. Mike, Lyndon, you’re both active investors. Are there any specific areas you would like to highlight?

Mike Matthews: In the portfolios that I manage, we have been increasing our exposure to interest rate risk and, for the first time in many years, my sterling investment grade funds have approximately the same duration as the sterling investment grade market. This reflects the fact that, while we are concerned about the potential stickiness of inflation, the level of rates now priced in (i.e. government bond yields) are offering reasonable compensation for interest rate risk.

Kate Dwyer: Thanks Mike. And are there any particular names you can highlight as case studies?

Mike Matthews: Sure. So primary markets are also offering attractive opportunities. We have recently seen a swathe of attractively priced new issues, both across sterling investment grade and more widely, including in subordinated bank debt. Examples include Vodafone £ 5.125% 2052 and Barclays £ 8.407% 2032.

Recently, we have also invested in some longer-dated sterling investment grade bonds that we had chosen not to buy at the point they were issued, instead buying them in recent months at significant discounts. For example, during October, we purchased the AA-rated Shell £ 1.75% 2052 bond. The bond, issued in September 2020, was added at a price of 38.4. 

Kate Dwyer: Lyndon, you manage a globally diversified IG credit strategy. Let’s talk a little about that. Are there any regional areas of opportunity that you’re particularly excited about right now?

Lyndon Man: Yes, so we think that Asia could offer an upside growth surprise, given the prospect of China reopening its economy. We like the region, particularly relative to the US.

Kate Dwyer: Thanks Lyndon, that’s interesting – and something I think clients will be keen to hear a little more on. Historically, the performance of emerging markets has been closely tied to global growth expectations so, with all this talk of recession, what is driving your optimism for the region?

Lyndon Man: Good question. Our interest is largely driven by the fact that the US experienced strong outperformance in 2022 on expectations of a soft landing. Going forward, though, monetary policy tightening should dampen US growth. As a result, we expect the divergence of growth between the two regions to be reflected in credit spread performance. In addition to this, we’re also finding value across both state-owned and private sector names.

Kate Dwyer: And what about Europe and the UK? The regions suffered the worst underperformance in 2022, as they were directly impacted by the supply-side energy shocks from the Russia-Ukraine conflict. How are they looking going forward?

Lyndon Man: Well, after the tough period that you’ve highlighted Kate, I’d say that much of the weakness is now priced in. So, on that basis, we believe there is strong potential for the region to outperform on valuations and technical trends, especially with consensus positioning being quite bearish.

Kate Dwyer: And Paul, our fixed income ETFs are passive products. So obviously the question of a manager making active regional bets doesn’t apply here. Again, it’s more about giving investors that choice.

Paul Syms: Yes, that’s right. Our investment grade credit ETFs span sterling, euro and dollar exposures and this allows clients to target their desired regions and currencies, based on their macroeconomic outlook.

Incorporating ESG considerations into IG credit portfolios

Kate Dwyer: We have covered a wide range of topics today, mostly focusing on the macroeconomic outlook and how this is impacting investment decisions. But, before we conclude, I’d like to spend some time on a longer-term theme. No discussion would be complete without it. Let’s talk about ESG. Mike, maybe you can kick us off with some context.

Mike Matthews: Sure. So, over the last 10+ years, ESG has really gone from a “nice to have” to a “have to have” as far as many investors are concerned. Traditionally, it has been a little harder to implement in the fixed income than the equity space. But, in some respects, corporate bonds have been a good place to start.

One reason for this is that equity shareholders have voting rights, and so company management teams are incentivised to drive positive ESG change. Bondholders can work with shareholders to engage with company management teams on this.

Kate Dwyer: Thanks Mike. And, of course, ESG investing allows clients to align their portfolios with their values, which is important. But, from a financial perspective, there can be benefits too.

Lyndon Man: Exactly. Beyond any ethical considerations, many credit events have their roots in some kind of environmental, social or governance-based deficiency. So it’s important to us that ESG is incorporated as a fundamental part of our credit research process. Our analysts assign credit and ESG scores and trends to every issuer they cover.

Kate Dwyer: Paul, Mike has introduced the concept of active engagement and Lyndon the concept of active credit research. Meanwhile, there’s a common misconception that ETFs can only go so far in terms of incorporating ESG. Is this something you would challenge?

Paul Syms: Yes, absolutely. Originally, ESG ETFs began by avoiding controversial industries and activities. However, since then, a wide range of strategies have evolved to fill the gap between simple exclusions and “best-in-class” approaches that seek out companies doing the most good.

For example, many of the engagements led by Invesco’s in-house ESG team pertain to our entire physically invested fund range. In other words, passive investors benefit from our active engagement processes. In my opinion, this is one of the best examples of how Invesco’s global scale can bring advantages.

Kate Dwyer: And Paul, that idea of an ESG spectrum is one that comes up a lot – empowering clients to choose the ESG products that best match their values and objectives. I know it’s something that our product development team have been working hard on over the last few years as well, really expanding the range of ESG capabilities we offer.

Mike, all of the fixed income products that your team manages integrate ESG considerations, but you recently launched an Article 8 and an Article 9 product as well. Could you talk a little about the differences there in terms of approach?

Mike Matthews: Sure. The Article 8 and 9 products that we offer are not pure investment grade strategies, but they do have a sizable allocation to investment grade corporate bonds. Each of the funds has a climate objective as well as a financial one: to support the transition to a low carbon economy.

In terms of what this means in practice? Well, on the one hand, avoiding issuers like mainstream fossil fuel companies. Despite their investment in renewables, we believe they will be reliant on oil and gas activities for many years to come. But, on top of this, we also actively select companies that are making better progress than their peers.

This can mean adding exposure to things like green energy and electric vehicles. But it can also mean investing in companies in carbon-intense sectors – if they are progressing faster than competitors.

Kate Dwyer: Lyndon, I know you’ve recently launched an Article 9 product too. You have also started incorporating a net zero protocol across three of your IG corporate bond portfolios. Is there anything you would like to add to close out today’s discussion?

Lyndon Man: Thanks Kate. I’d just like to spend a moment on that final point Mike raised, i.e., the concept of investing in ESG progress as well as ESG perfection. It’s an important point and, from my perspective, the best way to drive real-world change. That’s why we carry out a coordinated programme of engagement to help issuers on the path to net zero. All sectors will need to decarbonise if we’re to achieve net zero by 2050 so, while divestment can be a useful tool as a last resort, we think that active ownership is more effective.

Kate Dwyer: Thanks all, for an interesting discussion. That’s given us a lot to think about. 2022 was an interesting year, to say the least, and there’s a lot to think about as we navigate 2023 too. As ever, we’re here to answer any questions that you may have, so please do get in touch.