In October, the spread of the iBoxx Euro Corporates Index widened by 6 basis points to a level of 134 basis points over the swap curve. This is equivalent to approximately 215 basis points over the government bond curve. The index earned a total return of +0.13%. German 10-year government bond yields closed October at +2.14%, representing an increase of 3.5 basis points compared to the end of September 2022.

In October markets started out on a constructive tone with spreads tightening approximately 10 bps. This changed at the end of the second week and spreads started to widen again. Weak economic data, continued geopolitical upheaval, heavy primary activity with sizeable NIPs and inflation staying at elevated levels soured the mood. Spreads climbed by almost 30 bps intra month from low to high in two volatile trading weeks. Thereafter, the market slowly turned more constructive. Again the hope increased for a FED ‘pivot’. Loosely defined, with the FED pivot market participants envision that the FED will slow or stop and even reverse its interest rate hiking campaign. The pivot proponents find that the FED has hiked enough or even too much and with that it is making a mistake that will hurt the economy. A lot of the investors in this corner belonged to the now ill-famous camp transitory that believed that the 2021 inflation spike would be temporary and disappear out of itself in 2022. We strongly disagreed with this in 2021 and we are also not a big fan of some of the claims of the pivot thinkers. Inflation is still too high and so far has not reacted to central bank tightening. Economic activity in the US remains brisk. Rates in Europe are still very accommodative vs the level of inflation. Several studies have shown the historic stickiness that inflation exhibits when it tops the 5% level. We do agree that the FED can slow its hiking campaign as its short term rate is now close to the inflation rate. However we find it highly unlikely that the FED will cut rates in the next two years. As said before, inflation that has topped the 5% level in general takes years to get back to former trends. The FED wants to be very sure that inflation will be on a sustained downward path. They want to avoid making the same mistake as the 1970s FED that lowered rates when inflation seemed to cool but had to reverse this when it picked up again. As a result we remain cautious on the market but try to capture the various opportunities the volatility and dispersion provide us.

On a positive note, the political situation in the UK quickly stabilized in October. Investors displayed trust in the new Prime Minister Rishi Sunak and the new Chancellor of the Exchequer Jeremy Hunt. Also, with hindsight, it is clear that the BoE played its cards well by first offering liquidity to pension funds that needed to sell gilts to increase their collateral positions but also by urging them expedite this in order to avoid creating moral hazard. Furthermore they are now in a better position to start quantitative tightening which they had to postpone at the height of the crisis. The economic situation in the UK remains dire however.

The 10 year German government bond yield increased by 3.5 basis points, French OATs tightened by 4.5 bps and Italian BTPs even tightened by 22 bps. Also, UK 10 year Gilt yields tightened by 57 bps. The important German – Italian government bond spread has now been relatively stable around the 215 bps level since the beginning of May.

Most of the economic data published last month, such as the JPM Global Composite Purchasing Managers’ Index (PMI), which dropped to 49 in October, continued to illustrate the slowing of the global economy. In the US, higher rates are especially causing the housing market to slow down. This also affects certain related sectors. The economy overall remains relatively strong however with a very low unemployment rate and employers still struggling to find enough workers. This did not change in October.

In Europe the economic situation looks bleaker than in the US but the expected sharp downward contraction keeps being pushed out. The German GDP print came in much stronger than expected at +0.3% quarter-on-quarter, supported by private spending, despite cost of living pressures and economic uncertainty. The energy crisis remains the key risk for Europe with the unusually warm weather in October leading to lower gas prices. Winter gas prices are down by about 60% since the peak in August, they however remain higher than the 2021 average. Europe announced new plans to tackle the energy crisis that included a first version of a price cap and a common purchases system. These measures, together with several new fiscal stimulus support plans, should help both households and businesses. The eurozone PMI surveys reached levels that are consistent with recession. October’s flash composite PMI registered a fall to 47.1, with the manufacturing index at 44.2 and services at 48.2. Inflation in the single currency bloc rose to 10.7% y/y, and core inflation at 5% y/y.

At the 20th Party Congress President Xi was reappointed as expected. China’s Caixin September services PMI showed a sizable fall of 5.7 points to 49.3 due to the latest Omicron wave. Real GDP growth rebounded to 3.9% y/y in the third quarter, beating market expectations. The manufacturing sectors have led the recovery, although the service sectors are still suffering from sporadic lockdowns across the country.

At the end of October we increased the risk position in the fund by buying longer duration credits. We remain underweight the long end of the curve but wanted to reduce this underweight as it had worked well and curves steepened here and there. As a result we went to a slightly overweight risk position from an overall beta perspective. Wider spreads and increasing dispersion continue to present interesting relative value opportunities. On the flip side, earnings warnings are punished harder than in the past, especially in the BBB- category.

Issuance in October stood at €38.0bn, slightly down vs September but still a good level considering the earnings season. The split between Financials and Corporates was €15.7bn and €22.3bn, so another month where corporates issued more than financials. Within corporates, utilities were quite active. Net issuance was €6.0bn.

Monthly flows were positive at €85m. This is a contrast with September, where credits saw outflows of €2.5bn. Cumulative outflows stand at €17.2bn, ~6.4% of AUM according to Barclays. The propensity for issuance in more supportive market conditions was already visible in October. Now, with a (not so bad) earnings season almost done and a still more benign market environment, November can see a ramp up in issuance. A large volume of issuance is likely to weigh on secondary spreads unless there are decent inflows in the asset class.

The portfolio delivered a return of +0.23% (gross). This was 10 basis points above the benchmark return of +0.13%. During the month, the portfolio’s sensitivity to market trends varied between 97% and 101% in beta terms. The portfolio is underweight spread duration, mainly at the longer end of the credit spectrum where credit curves remain relatively flat. The portfolio remains invested in defensive off benchmark segments such as covered bonds, agencies and supranationals. The portfolio continues to have an underweight in BBBs, a reflection of tight valuations at an issuer level given the uncertainty surrounding the market and economy.

With spreads slightly wider over the month our exposure to defensive off benchmark segments (in covered bonds and cash) contributed positively to performance while government bonds, agencies and supranationals had a small negative contribution. Our positioning in telecommunications, media and real estate had a positive contribution, while banks and food & beverage contributed negatively this month. On an individual issuer level the strategy saw a positive contribution from our overweights in Repsol, Netflix and Aroundtown. Our overweight in CBRE and our underweights in Volkswagen, Total and Generali had a negative impact on performance.

In October, the Fund participated in new deals from EDP, Smith & Nephew, Deutsche Bahn, Carrefour, Vattenfal, Tennent and Verizon amongst others. On the financials side, we participated in Jyske Bank, ALD, AXA, BBVA, OP Bank, Raiffaissen Schweiz and Rabobank amongst others.

The bonds from EDP, BBVA and Tennet were in green format. The Carrefour bond has Sustainability Performance Targets (SPTs) related to tonnes of packaging avoided and the reduction in food waste generated by the stores. If Carrefour fails to realize the targets formulated they need to pay a 25 bps higher coupon per SPT in the final year of maturity.

Outlook
Although credit spreads are at relatively attractive levels, we remain on the cautious side. We see more risks on the horizon, including a prolonged Russian invasion, uncertainty regarding European energy supply and security, weaker global growth and stubbornly high inflation. We are still moderately bearish and think spreads could widen due to the weaker macro-economic environment, expectations for aggressive hiking by central banks and impact over time of Quantitative Tightening globally. Q3 2022 company results were relatively solid so far but we fear that higher rates and a potential recession in both Europe and the US over the next 18 months are not adequately reflected in earnings and profit guidance at present. Spreads are too low to fully compensate for the risks that we have identified. The technical backdrop is not supportive with supply that needs to pay sizeable NIPs to be able to print. We expect spreads between rating categories to decompress. We are underweight the BBB segment as a result. Lastly we are also underweight spread duration.