Impact Credit Insights by Luca Manera, Investment Manager
12 April 2023
The first quarter of 2023 will be on the record books, as markets have been on a rollercoaster ride driven by a surge in volatility. January kicked off with a record start for European equities and a continued rally in credit, by February the resilient economy and sticky core CPI prompted a sell-off in interest rates, with 2-year US treasury and German bund yields jumping past 5% and 3% respectively. Markets re-priced an acceleration of central bank policy with higher peaks for longer. By early March, European investment grade tested the lows of October and US bonds retraced all the gains. The narrative changed by mid-March, as two US banks collapsed, and Credit Suisse was sold over the weekend to its rival, bond returns recovered, albeit not for Credit Suisse AT1 holders. The Nasdaq index topped 20% from its recent low meeting the definition of a “bull market”.
As bond investors hold onto their hats, we look at one bond measure that continues to offer a silver lining in this fast-evolving market.
Q1’23 Bond returns: Saved by the banking crisis
A rollercoaster ride for interest rate pricing
Volatility came back with vengeance in the bond market. In just three months, market pricing of central bank rates changed dramatically from “higher rates for longer” to a re-acceleration of a hiking cycle and shortly after followed by pricing of deeper cuts. The ICE Move index (implied volatility of US treasuries) surged to levels that were last seen during the financial crisis, as front-end treasuries whiplashed by 100bps in just a handful of days.
Rollercoaster pricing: from more hikes to deeper cuts
The economic data in February continued to point towards a resilient core CPI and economy. By March 6th, markets priced 2 additional hikes in the US and 3 more in Europe, with a peak of 5.5% and 4% respectively. European government bond returns dropped to 12-month lows. In the span of a handful of days, two US banks collapsed, and Credit Suisse was sold to its rival, marking another record for the quarter: the first failure of banks from the financial crisis, including a global systemic bank. Investors slashed their views about the FED policy rate by pricing 3 interest rate cuts, a stark contrast compared to a few weeks back. Bond prices jumped and curves steepened propping up the asset class, saved by a banking crisis.
Feeling less dizzy thanks to yield breakeven(s)
Despite the market gyrations, yields continue to hover close to January levels, which brings investors back to the start of the year, but with a very different outlook. Inflation remains the key risk for central banks, as core component is more entrenched. At the same time, the banking crisis has now added another headache; to ensure financial stability. In the current outlook where volatility remains elevated, bond investors can focus on one measure that offers a silver lining: the yield breakeven.
The yield breakeven helps estimate how much interest rates can increase before the bond yield is underwater. Alternatively, it can also be interpreted as the amount of yield compensation for taking interest rate risk. Over the past years, yield breakeven(s) have been eroded due to falling yields and increasing duration, this is not the case anymore. Despite the recent ups-and-downs, breakeven levels continue to offer a significant buffer against higher interest rates, making investors feel less dizzy about short-term interest rate movements.
Despite the recent rally in interest rates, yield breakeven(s) offer significant protection against interest rates
The current level of yield breakeven across investment grade markets is higher than in October 2022, despite yields being lower. As of March, the breakeven for the US treasury index stood at 60bps, a level last seen during the financial crisis. This implies that interest rates can increase by 60bps before the index yield of 3.8% is flattened. For European government bonds, the breakeven is 40bps, albeit not at the same level as during the debt crisis in 2010. In this case the index yield would need to jump to 3.4%, a level only reached in early March. The breakeven analysis is more complex for corporate bonds, as yields include credit spreads. This means that credit spreads can widen by more and generate negative excess returns, while still be within the breakeven level if interest rates fall. European corporate bonds offer the highest level of breakeven at about 90bps, in this case all-in-yield can widen past 5% a level last seen only during the financial crisis.
Breaking down Green Bond breakeven(s)
Currently, the green bond index breakeven sits at about 60bps, in line with the US Treasury index and higher than the Euro government index. This is largely due to the growing corporate credit component which now accounts for more than 50% of the index. A like-for-like comparison shows that moving into sustainable fixed income does not require a trade-off in terms of yield breakeven, for example the Euro Corporate Green Bond index breakeven is the same as its traditional counterpart at around 90bps.
Preparing for another ride
To conclude, the start of the year has been turbulent for investors as markets whiplash between fast-evolving market events. Downside risks remain for bond investors driven by inflation, central bank policy and growth. At the same time, investment grade bonds continue to offer significant protection against higher interest rates, while yields remain historically high. By focusing on yield breakeven, investors can navigate interest rate volatility and feel less dizzy on the next ride.