For the first time in three years, interest rates should no longer be a headwind for credit markets in 2024, but other forms of uncertainty may affect climate-aware bond investors. Our credit experts discuss the key themes they expect to play out over the coming months.
Read this article to understand:
- How climate-focused credit performed in 2023
- How these markets are set to evolve in 2024
- Key risks and opportunities for climate-aware investors
Following a tough 2022, last year brought more challenges for credit markets. But despite volatility around the mini-banking crisis and ongoing geopolitical tensions, credit spreads ended the year tighter , partly because the expected recession did not materialise and markets started to price in a “soft landing”, further encouraged by the dovish pivot on the part of the Federal Reserve (Fed) in December. As illustrated by the contained effects of the Credit Suisse collapse in the first quarter of the year, central banks also remained capable of protecting financial markets from shocks.1
Looking ahead, the path of interest rates is once again dominating the conversation. Many investors seem confident of a rapid return to a low-yield environment, despite a lack of robust data to support this view.2
Meanwhile, widespread flooding in the UK and Australia in early January indicated the effects of extreme weather will continue. Scientists pointed to the role of climate change in increasing the severity of events such as Storm Henk, which battered British shores and focused minds on the need to ensure public infrastructure has the necessary resilience.3
The impacts of such climate risks on investments will likely keep rising over the next few years and it is essential that investors start assessing their exposure. Although countries did not agree to a “phasing out” of fossil fuels at COP 28 in December 2023, their pledge to “transition away” from them means they will have to greatly increase their clean energy capacity.
The various pledges made at COP have focused minds on the need to accelerate climate transition investments
The various pledges made at COP have focused minds on the need to accelerate climate transition investments. In this context, our Climate Transition Credit strategy is positioning to take advantage of climate solutions and mitigate climate risks, as well as seeking the benefits of traditional investment-grade (IG) credit.
In this Q&A, Justine Vroman (JV) and Thomas Chinery (TC), co-managers of the strategy, look back at what worked (and what didn’t) in 2023, and discuss their views on interest rates, the progress of the climate transition and other key themes likely to influence performance in the year ahead.
How did the strategy perform in 2023?
TC: From an overall IG perspective, we were surprised at how resilient US credit markets proved, despite the persistent fears over a looming recession (which, in the event, were never realised). But US spreads still look quite tight and of the two markets, euro zone credit currently looks more attractive.
JV: Looking at the strategy, our overweight euro and sterling credit allocations performed extremely well, notably driven by the compression of subordinated debt in sectors such as banking and utilities. In dollar credit, we were largely underweight, essentially based on tighter valuations. That contributed negatively from an allocation standpoint because dollar credit surprised us to the upside. In particular, our cautious stance on longer-dated dollar credit detracted from performance as the credit curve flattened aggressively. However, this was offset by our dollar credit selection, notably in banking and telecoms, which proved strongly additive.
In terms of sectors, banks offered interesting alpha opportunities underpinned by higher volatility and proved to be the main contributor to the fund’s outperformance. That was followed by telecoms, where we selected issuers that were deleveraging, such as Vodafone, AT&T and rising star Cellnex. Industrials also contributed positively thanks to our selection of climate solutions providers such as Danfoss, Trane Technologies, Xylem, OCI and LG Chemicals.
Climate solutions often feature in capital goods and basic industry sectors. These didn’t do particularly well in 2023, the former being a defensive sector that tends to underperform in a credit-spread tightening environment, while the latter was impacted by the negative outlook, notably on chemicals. Yet there was dispersion at the issuer level and a number of companies did extremely well, supported by green capital expenditure and incentives such as the Inflation Reduction Act (IRA), a policy initiative designed to facilitate investment in renewable energy and other climate-friendly technology in the US. Credit-specific developments, such as Newcrest being acquired by higher-rated Newmont, also played a role.
By contrast, our underweight on technology and media contributed negatively given the robust performance of that sector.
Specifically considering climate-aware strategies, 2023 was challenging given that energy again outperformed the overall credit index in terms of both total and excess returns. However, this was offset by our investments in high-impact sectors such as utilities, notably hybrids from European electric utilities leading the energy transition, like Enel and Iberdrola, which outperformed – although past performance is not an indication of future returns.
It was a strong year for sustainability-linked bond (SLB) issuance. How do you view the current state of that market?
TC: SLBs came under scrutiny in 2023, facing criticism over their specified sustainability targets and whether these were ambitious enough, rather than for their financial performance. Most IG SLBs look to have ambitious targets relative to emerging-market and high-yield SLBs where the story is often quite different.
However, sentiment appears to be shifting and there are signs market participants are starting to look more favourably on SLBs. For example, if an issuer misses its sustainability targets, this is now often seen as evidence it has ambitious goals, rather than that it is failing altogether on the sustainability front.
Other forms of labelled bonds, whether green, sustainable or social bonds, have also seen robust issuance of late. Liquidity remains compressed in those structures, but diversification in terms of names and sectors continues to grow as they become a bigger part of the market. We decide to invest on the basis of an issuer’s overall approach, both in terms of the climate transition and its underlying financials, whatever type of bond it issues. But this is certainly an area to watch as the market for labelled bonds grows and becomes more mainstream.
How is the expected path for interest rates shaping your view?
JV: A big change from the past three years is that, in 2024, rates should no longer be a headwind to performance in credit. The broad message from developed-market central banks is that we are likely at peak policy rates, although caution is still required as the journey to take inflation back to target may not be fully completed. Therefore, we expect their decisions to remain data dependent.
However, even though the Fed has turned more explicitly dovish, signalling a pivot to rate cuts at its December meeting, the large move in rate expectations we saw at the end of 2023 may have gone too far, too quickly.4 The cuts being priced in for 2024 seem very optimistic, especially in Europe. In fact, because of macro factors, the ECB could be in a better position to cut first, but has remained more hawkish than the Fed. It recently gave soft guidance for “rate cuts by summer” but also warned the path of cuts priced in by markets could be self-defeating as overly easy financial conditions might stimulate a return of inflation.
Therefore, we may see slight reversals early in the first quarter and we would anticipate expectations to be more range-bound after that. Overall, however, rates are likely to boost total returns for credit in 2024, and lower rate volatility would also be supportive of credit spreads.
A caveat to this is the significant supply from the US and European countries expected in 2024. It remains to be seen whether the market will absorb it all; quality assets, including IG issuance, will be competing for investor demand.
Finally, with potential normalisation on the horizon, we should see some rate-curve steepening at some point in 2024. That should encourage investors to rotate some short-term credit exposure further down the curve to optimise “carry and roll”. [Carry refers to coupon income investors receive; roll to the practice of “rolling down”, or exploiting the shape of the yield curve to take advantage of the fact spreads tighten as bonds near maturity.]
TC: Two additional elements could support demand. Firstly, if the front end of the rate curve does depress, that will encourage movement from money market funds into credit funds. Secondly, as credit funds benefit from higher coupons, they will reinvest the proceeds into the market, creating a further boost in demand.
The difficulty is in estimating whether corporate treasurers might increase new issuance. Certain hybrid instruments are now yielding two per cent less than they did in October, making it more attractive to issue longer-dated bonds and lock in lower yields for longer. We could therefore see some additional issuance which could lead to some steepening of credit curves. However, that will depend on the supply and demand balance, which is a very hard thing to call. As a result, we are positive but slightly cautious in our outlook.
Where do you see potential opportunities in the months ahead?
TC: Companies that provide technical solutions to the challenges caused by climate change are the enablers of net zero that should continue to benefit from the energy transition. Transition-oriented companies are those which, across all sectors, are managing their transition risks and improving their climate resilience. As you might expect, renewable energy, electrification and sustainable transport are key themes here, but so are water scarcity, waste management, and the contribution to building smart cities and a circular economy.
Looking into 2024 and following the COP28 summit, we expect an increasing focus on energy-efficiency solutions, as multiple countries have committed to working together towards doubling the global average annual rate of energy efficiency improvements from around two per cent to over four per cent every year until 2030. That should be supportive of companies active in this area.
In parallel, given the current constraints on rare metals and the challenges around energy storage, the need to diversify investments in potential climate solutions such as nuclear and hydrogen power generation is increasingly recognised. An interesting development at COP28 was the growing acceptance of nuclear energy as a decarbonisation solution to complement the growth in renewables. While the goal of a tripling of nuclear capacity by 2050 is some way off, it could be a tailwind for industrials companies active in the nuclear supply chain.
JV: On a broader IG level, IG credit remains very compelling; median forecasts are for it to deliver mid-single-digit total returns. Yields started the year at around five per cent, which is healthy but also provides a lot of downside protection to absorb volatility. And whilst fundamentals and ratings would likely deteriorate in the event of a macro slowdown, we expect IG to remain resilient overall. In fact, although past performance is never an indication of future returns, it is worth keeping in mind that IG outperformed riskier asset classes such as equities and high yield during periods of business cycle contractions over the last 20 years. And, obviously, defaults in IG are rare.
The other aspect is technicals, which remain very supportive. While there remain question marks over the level of supply, it is unlikely to be overwhelming in credit, whilst demand from yield-oriented investors should naturally remain strong. Overall, we are reasonably optimistic for the return potential in IG this year.
In this context, we are positioning for defensive carry and decompression; overall, we have shifted towards higher-quality bonds. We are more cautious on BBB-rated bonds and those from issuers in cyclical sectors, while remaining highly selective on BB-rated bonds. We like subordinated debt, but only from strong IG issuers, and we prefer more-defensive sectors like telecoms, utilities and healthcare. We continue to like financials, but are focusing on larger banks as opposed to regional lenders, especially in the US. Overall, we expect to see more dispersion between issuers, which should offer alpha opportunities for active asset managers.
Another theme is a convergence between European and US spreads that should play out in various scenarios. In a range-bound spread scenario, Europe’s extra carry should be supportive, but even if there is more of a sell-off than expected, the expensiveness of US credit will remain a factor, so that is a theme we are positioned for.
What are your biggest hopes – and biggest concerns – for 2024?
TC: My hope is that we remain in an elevated yield environment which makes credit very attractive as an asset class, with dispersion between credits allowing individual stock selectors like ourselves to generate returns based on fundamental analysis and a view of companies’ prospects.
My concern is we hit periods of significant rates volatility whose drivers become detached from fundamental concerns, and that we return to an environment characterised not by credit strength but by rate movements. This was the situation throughout most of 2023 when much of the volatility was challenging, although there was dispersion within it that allowed active investors to generate returns.
The markets finished 2023 strongly, but at the beginning of the year no one would have forecast we were going to lose a huge bank like Credit Suisse. These are the unknown unknowns that can affect markets, making it important to maintain discipline around the investment process.
On the climate side, we are not currently seeing significant distress among specific issuers as a result of climate risks, but we expect this to become more of an issue over time. Climate events are likely to become more frequent. Low water levels in the Rhine, which have disrupted shipping and increased freight costs for German industrials in the past, and which have been linked to rising global temperatures, are a good example. But mostly we expect pressures to keep building over the medium term, as highlighted by rating agency Fitch, which expects over half of corporates facing climate-related downgrades by 2035 to be IG.
JV: A soft landing for the global economy would be the most positive outcome from an excess and total return standpoint. That’s a risk to the upside, with spreads likely to push tighter from here in such a scenario.
But in the wake of the rally we had at the end of 2023, it feels like markets are priced for perfection, despite the range of possible outcomes being probably broader than usual. In my opinion, risks are skewed to the downside, and any deviation from the current path is likely to have repercussions on spreads as valuations are relatively stretched. Therefore, while we are still very positive on the asset class, we have taken some profits and sought to keep some dry powder ready to deploy when the time is right in 2024.
In terms of my chief concerns, one is a deep recession in the US and a deeper global slowdown. Another is inflation shooting back up and forcing central banks to make further aggressive hikes. That would bring back rates volatility and, possibly, a positive correlation between rates and spreads, all of which would be negative for total returns.
Another variable to consider will be the potential impact of the US elections on the country’s climate ambitions. In many cases, the progress companies are making towards the transition, and the targets they are setting, are independent of politics. However, one obvious variable will be changes to environmental policies and incentives such as the IRA, which are supporting green investments.
Finally, following on from Tom’s point, we can’t exclude another potential shock putting market stability at risk, akin to the liability-driven investment (LDI) crisis of 2022 or the collapse of Credit Suisse in 2023. That is something at the back of my mind, especially considering how high rates are, alongside the potential for a broadening of the current conflicts in the Middle East and Ukraine, or new geopolitical tensions.
