Bonds can return to ‘traditional risk-off role’ in 2023

Market uncertainty remains but ESG bonds continue to be attractive to investors

Although 2022 was painful across asset classes, arguably the epicentre of the pain was bonds as stubborn inflation and aggressive central bank action pushed yields from a very low base, according to Will McIntosh Whyte, fund manager at Rathbone Greenbank multi-asset portfolios.

However, Whyte said the reset has provided an attractive entry point, particularly for government bonds.

When it comes to governments issuing ESG bonds specifically, the signs appear encouraging, particularly in emerging markets. In November 2022, the World Bank found the share of green, social, and sustainability or sustainability-linked bonds issued by emerging market governments has grown in recent years, with 18 (total issuance of $70bn) of the 40 sovereign borrowers that have issued between December 2016 and September 2022 coming from low and middle-income countries. 

In developed markets, the higher levels of yield for government bonds means they can return to their role as a traditional risk-off asset, providing a negative correlation to risk assets, particularly if we continue on the trajectory towards recession.

“We expect inflation to fall materially through 2023, which should remove one of the key headwinds for the asset class,” Whyte added.

“At these levels of yield gilts and US treasuries can now provide meaningful returns – we prefer exposure to US duration, but access this through US dollar-denominated supranational bonds as US treasuries do not meet our sustainability thresholds.”

ESG bond market grows

But it wasn’t just ESG government bonds causing a stir in 2022. By July last year, the $1trn green bond marketplace, having initially been dominated by quasi-sovereign issuance, was a 50/50 split between sovereign and credit issuers.

“Banks have played a key role and continue to do so, but we have also seen a substantial contribution from many corporate sectors such as real estate, telecoms, autos, chemicals and consumer goods,” Johann Plé, portfolio manager at AXA IM said at the time.

“More and more sectors are seeing the sense of investing in the transition and seeking funds that can help them reduce their exposure to climate change – or maybe adapt to the effects that a transitioning economy may have on demand.”

David Arnaud, senior fund manager at Canada Life Asset Management, told ESG Clarity he expects investors will continue to be interested in ESG-labelled bonds, which he added now represent more than a third of issuance in Europe.

Indeed, ESG Clarity EU covered the launches of ESG fixed income funds from HSBC, EdenTree, Candriam and Franklin Templeton last year, as well as BlackRock’s impact bond fund and Nordea, NNIP and Franklin Templeton’s social bond funds, among others.

ESG corporate bonds

Whyte said the reset has also improved returns on offer from corporate bonds where one is now being paid sufficiently for both the risk of default and the liquidity risk inherent in this asset class.

However, he added spreads have tightened a bit from the significant weakness in the autumn of last year, and there may well be more attractive entry points over the next six months.  

Arnaud commented we may not be out of the woods of last year’s rate hike and tightening environment just yet.

“We still have not received the all-clear on long-duration bonds, and risk assets (equities and corporate bonds) will struggle to perform,” he said.

“Our focus will be on carry trades by identifying assets with attractive income generation potential and resilient features to the upcoming recession. Subordinated debt by strong financial institutions ticks all the boxes.”

For Fatima Luis, senior portfolio manager at Mirabaud Asset Management, it will be investment grade corporates that will be getting a look-in at the start of this year as the market adjusts to slower inflation and slow growth.

She added: “Once the market prices in a more difficult economic environment then we expect opportunities to emerge at the riskier end of the credit spectrum, primarily in high-yield corporates.”