Siddhartha Bhattacharyya, Iain Forrester and Matthew Raque from our buy-and-maintain credit team discuss the impact of the current environment on portfolios, where they are finding value, and how they are integrating these considerations in their net-zero plans.
Read this article to understand:
- The impact of inflation on buy-and-maintain credit portfolios
- The outlook for various sectors and geographies
- What it means for portfolios transitioning to net zero
After the debacle of the “mini-budget” in September, UK Chancellor of the Exchequer Jeremy Hunt’s Autumn statement on November 17 was always going to be a more prudent affair. Brought in to reassure markets as to the government’s responsibility, Hunt steered the budget back towards what investors wanted to hear.
The five-year fiscal programme represents a significant tightening, delivered as the UK falls into recession and as households are already feeling painful cost-of-living pressures, but it will take some pressure off the Bank of England if demand restraint is still needed to fight inflation. The short-term impact is much smaller, but at least fiscal and monetary policy are not pulling in different directions.
In this context of high inflation and still-volatile interest rates, the goal of buy-and-maintain credit investing – to provide clients with long-term excess returns over government bonds while remaining within a defined credit risk budget – has become more challenging.
Siddhartha Bhattacharyya (SB), Iain Forrester (IF) and Matthew Raque (MR) from our buy-and-maintain credit team share their thoughts on how the market environment is affecting their outlook.
How are you managing buy-and-maintain portfolios in the current environment of high inflation and volatile interest rates?
IF: In our portfolios, we manage to a target duration or interest-rate profile, which is typically aligned to our clients’ liabilities to their customers or pensioners. What we also then see is our clients hedging any additional rates and inflation exposures, so there is limited direct impact on our portfolio objectives in normal conditions.
That said, the volatile interest-rate environment in the UK over the last two months illustrates the indirect impacts of that hedging activity can be material. For example, where a pension scheme needs liquidity, it can be delivered from buy-and-maintain portfolios – through direct sales or indirect mechanisms such as repurchase agreements (repos).
We have also seen significant falls in bond prices, through rising yields and spreads. The higher spread levels have made for a much more attractive entry point, although it has contributed to the pick-up in tender activity in the UK market.
SB: In portfolios where we have scope to manage our duration exposure, we were positioned conservatively as we went through the summer and have therefore benefitted from the rises in rates and spreads. And with the recent widening in credit spreads, we have been redressing some of that short positioning and starting to go back into the market.
We still see some names and markets where spread curves are fairly flat beyond a certain date
We still see some names and markets where spread curves are fairly flat beyond a certain date. That is one area where there may be value in exiting or switching those positions into names where the curves are steeper. We are therefore looking at substitution trades where we think the longer end of the curve in some names is tight relative to the market, to take advantage of that. And the benchmark-agnostic nature of our portfolios gives us the freedom to be overweight or underweight certain names, which helps manage our exposures to inflation and rates.
This ongoing optimisation activity is a key element of our buy-and-maintain portfolios. While much of our attention is focused on putting money to work, and we expect to be able to hold any position until maturity, we constantly monitor our investments with a view to adding value.
MR: We invest on a buy-and-maintain basis across developed and emerging markets. In emerging markets, inflation tends to have a more profound impact, particularly in the core categories of food and fuel that hurt consumers most, as we are seeing now.
From a credit perspective, the impact is mostly contained and the central banks in these countries have responded fairly aggressively, just as the US Federal Reserve (Fed) is doing. At the same time, we recognise and monitor the impact inflation has in these nations and the social unrest it could cause. Our investment decisions will be driven by our view on whether the governments or central banks can respond appropriately to those challenges.
How are utilities and other energy providers affected by current energy prices?
IF: Utilities have naturally been an area of focus. We limited new investments into the sector while the Russia-Ukraine war unfolded. More recently we have added defensive positions, including in electric-grid names, where new issues have been very well subscribed, and in our preferred names like Enel. Ongoing capital investment in this sector is an integral part of supporting the low-carbon transition.
SB: In this energy crisis, everyone is debating how utility companies will be affected, but most people are not thinking about industrials, who are big end-users of energy. But utilities will get government support because they are needed for day-to-day life, whereas a chemical company may not. The cost it may have to bear is something investors need to be careful about. At the moment, the risk/ reward compensation is not adequate.
We have seen oil majors benefitting as the spike in energy prices ballooned their balance sheets
We have also seen oil majors benefitting as the spike in prices ballooned their balance sheets. Some governments are discussing windfall taxes, but energy companies should be able to weather that. How they will reinvest that money remains to be seen – their capital expenditure plans, specifically with regards to the energy transition, are key to our investment views.
We have also seen windfall taxes in the utility sector, including where renewable players are benefitting from relatively limited additional costs coupled with a much higher power price. For example, ENEL was recently stamped with a hefty windfall tax, but even that added only about 0.1 times to its overall leverage.1
Conversely, there are institutions like EDF that are negatively exposed to the power price. EDF has to provide power at a fixed price which, when its generation capacity reduces, means it has to buy in the market. That is having a significant impact on the company, particularly in light of the French government's request to increase the power delivered at that fixed rate. EDF expects to lose up to 29 billion euros.2
MR: In the US, we have very little exposure to utilities. The carbon intensity of US utilities is typically materially higher than those of European peers. There is also extensive use of coal that violates our baseline exclusions policy. In general, US utilities have been slower to commit to specific timelines for phasing out coal usage while also lacking a commitment to follow science-based targets for emissions. There has been pressure from the investment community on US utilities to enhance their various ESG considerations; however, we believe there is still room for improvement and clarity compared to European peers.
US utilities have more diversified fuel sources and are not reliant on importing natural gas from more hostile countries
US utilities are also relatively well insulated from energy prices, so they have not been significantly impacted by the energy crisis. In general, US utilities have more diversified fuel sources and are not reliant on importing natural gas from more hostile countries (i.e., Russia). While the US produces an abundance of natural gas, there are logistical issues transporting it across the country, so US utilities still face some supply issues related to the increased worldwide demand for non-Russian natural gas. However, the overall cost of natural gas in the US is still significantly cheaper than in Europe, so American utilities are not facing the same supply crunch.
Are you seeing anything different in emerging markets?
MR: Some of the Middle Eastern and other oil-and-gas producing countries are benefiting from the current uncertainty. They are probably more stable than some countries in South America and Central and Eastern Europe.
However, while this has been beneficial for their balance of payments and fiscal positions, there are wider environmental and social considerations. What are the governments’ plans for diversifying their economies? How are they looking to diversify their power sources, such as solar power? Are they taking sufficient action to address concerns around human rights?
We are also seeing significant social unrest driven by the cost-of-living increases. In several countries, large groups have been protesting pre-existing legal and leadership structures in their countries. Some of this has led to a shift to more progressive policies and greater involvement of the state in day-to-day operations, whether through pensions or intervening in the economy to help citizens deal with these inflation-related issues.
What other sectors and geographies are faring well, and which are lagging?
MR: As a result of the continued challenges in taming inflation, we are cautious on lower-quality retail names as consumers trade down to store-brand items and move away from more discretionary purchases.
We are selectively positive on retail names that can pass through higher input costs and maintain margins
At the same time, we are selectively positive on retail names that can pass through higher input costs and maintain margins. This tends to be larger companies, such as Home Depot or Walmart, which are better able to weather headwinds given their strong brands, scale and historically strong balance sheets. We have seen this come through in recent earnings for Walmart, which beat expectations and showed consumers will go to stores they believe can offer the lowest prices.
SB: A recent article about the cost-of-living crisis in the UK stated shoppers are moving from the likes of Sainsbury’s and Tesco into cheaper alternatives.3 But even within that universe, we are cautiously optimistic on Tesco and have seen it recently tender for secured debt.
In contrast, we see banks as beneficiaries of higher rates. Our portfolios have been overweight financials, which should counteract some of the negative effects of inflation on other sectors. Macro- and liquidity-induced volatility saw some underperformance in the sector during the third quarter, but spreads are now coming back to late summer levels.
Within the US, other preferred sectors are universities and high-quality corporates
Within the US, other preferred sectors are universities and high-quality corporates. During most of 2021, underlying bonds within these sectors were trading expensively. However, the volatility this year saw AAA-rated new issues from the likes of Harvard and MIT offering adequate compensation for long-duration risk.
Once those bonds are priced, their spreads tighten quickly, so to be able to build up size in these positions we have been quite active in the primary market. This has allowed us to pick up high-quality credits delivering 85 to 90 bps of excess spreads, so selective positioning in the long and higher-quality names has benefitted our portfolios in this period of spread widening.
MR: We also like US healthcare and pharma, because the sector has been fairly insulated from a lot of the macro uncertainty. There are always specific events in the US when it comes to regulation but overall the sector is defensive.4 We have seen several credit-rating upgrades of pharma companies who have de-leveraged their balance sheets after large M&A deals and where management moved to more conservative balance sheets to weather a potential recession. Despite some input-cost pressures on the healthcare and medical device side, companies tend to be able to pass these costs through to the end-user given the more inelastic demand for these products.
How do these conditions impact your net-zero plans and implementation?
IF: We recently published a paper on planning for net zero in buy-and-maintain portfolios, but I can share a couple of thoughts on what we are seeing in the current context (see ‘Buy-and-maintain credit: The long road to net zero’).5
The high price of gas in Europe has led to an increased use of coal and the extension of existing coal-powered stations’ lifespans. As firms and countries understand the extent of the crisis, their focus is on ensuring there is enough energy across the system through this winter and next. That may result in a delay or an adverse impact on short-term emissions.
Balancing that, the increased focus on energy security is resulting in a move to diversify away from gas and some of the associated regime risk – not just in Russia but other markets as well – and to accelerate renewable capacity more quickly than was previously expected.
SB: One key engagement theme for us is deforestation, which impacts both biodiversity and climate change. For instance, Home Depot uses wood for many end products. How is it planning to move away from that? How will it find alternative sources? Because deforestation adds to climate change, there is strong engagement between our ESG colleagues and the likes of Home Depot and Procter & Gamble on those questions.
We are pushing these companies to give more measurable numbers and plans for how they are tackling key ESG risks including climate change, but as we know, it is not going to be done with a flick of a switch. It is going to take time, and that is why continuous engagement and dialogue with firms are integral to our investment process.