Sustainable, responsible business practices and investment are a megatrend of our time, and we have been a pioneer in this field for many years. The conversion of Raiffeisen 304 – ESG – Euro Corporates was another milestone on this path, and also makes perfect sense from a risk-return perspective. At the same time, the recent sharp yield increases on the markets are offering new, improved return potential that has not been available from highly rated euro corporate bonds for more than a decade.
The key points
Combination of core Raiffeisen KAG competencies: global fixed income and sustainability
Good reasons to take ESG* criteria into account from a risk-return perspective as well
Massive yield increases opening earnings opportunities not seen in a long time
Fund management currently focusing on medium terms and quality and on financial bonds
A great deal of risk is already priced in, but further price declines are still possible (e.g. in the event of an unexpected deep recession, further geopolitical escalation, new sharp inflation increases)
As of 1 July 2022, Raiffeisen 304 – Euro Corporates switched to exclusively investing in sustainable bonds (sustainable fund pursuant to Art. 8 SFDR)*. As before, it continues to invest in investment grade corporate bonds that are denominated in euros, but the issuers must be categorised as sustainable on the basis of ESG criteria as of the beginning of July. This is also reflected in the fund name, which will be Raiffeisen 304 – ESG – Euro Corporates as of the beginning of July.
This step represents the continuation of Raiffeisen KAG’s conversion of its fund range to sustainable investments. Test runs for credit portfolios that are based on ESG criteria were successfully started several years ago, meaning that the fund conversion is based on many years of sound preparation. As a pioneer of sustainable investment in Austria, we have systematically built and expanded the required comprehensive know-how, including a database and investment processes, over the past years. It is worth noting that this has taken place with a high degree of personnel continuity. Raiffeisen 304 – ESG – Euro Corporates thus combines two core competencies of Raiffeisen KAG: global fixed income and sustainability.
Corporate bonds: why ESG analyses make sense
Responsible business practices and investment are now the talk of the town, but this is far more than just a “fashion trend” or politically-driven development. There are also good reasons for investors to pay more attention to ESG criteria from a risk-return perspective. Because all other things being equal, poorer ESG scores should also manifest as higher business and financial risks, thus bringing generally lower credit ratings, possibly lower share prices, and higher risk premiums. S&P Global Ratings (formerly Standard & Poor’s) explicitly considers corporate governance as one of its so-called rating modifiers, for example. Corporate governance, the “G” in the ESG spectrum, is certainly the dominant of the three ESG factors across all sectors for bond investors, but is not the only factor that is important. In fact, good bond investors and the rating agencies paid close attention to corporate governance before the inception of the ESG concept because it can have a direct impact on event risks and credit ratings.
Credit ratings are far more predictive of credit spreads than ESG ratings. But good or poor actions by companies in terms of ESG do have an influence on their credit ratings. There is thus a relationship between ESG risks, default risks, and ultimately risk premiums and even the long-term performance of companies and their bonds. This means that it pays to take ESG criteria into account when assessing risks and selecting (corporate) bonds, including from a risk-return perspective!
Sustainability in Raiffeisen 304 – ESG – Euro Corporates
Sustainability is managed actively in the fund at three levels:
As a pre-selection criterion (minimum sustainability, avoidance of certain issuers, practices, business fields, etc.); goal: definition of sustainability, minimum sustainability standards
As part of the strategy decision (individual issues must generally have a sustainability rating to be eligible, consideration of future topics, risk-based sustainability analysis); goal: maximum performance quality
Portfolio optimisation with a view to yield and sustainability (balance between the risk drivers credit spreads, duration, and sustainability); goal: sustainability impact
Ninety per cent of the fund portfolio must have a minimum ESG score of 50, and no more than 10% may have a lower score or no score at all in justified exceptional cases. The latter may make sense if it involves issuers who have made proven substantial improvements in this area, but that have not yet reached the threshold of 50. At present, around 84% of the fund has an ESG score of over 60. Just 5% has a score of below 50, or is not rated.
After the ESG conversion, the fund’s investment universe consists of around 2,500 bonds from roughly 500 issuers. This is still sufficiently broad, high-quality, diversified, and liquid to maintain the elements of the long-proven credit investment process aside from sustainability management (including bottom-up issue selection, top-down credit management, and duration management).
In addition to governance, the fund management also places a high focus on environmental and social factors. Thus, the fund holds significant investments in selected green bonds, social bonds, and sustainability-linked bonds (currently around 20% of the portfolio, twice the level in the benchmark).
Latest yield increases improving the risk-return constellations
The massive price declines of recent months are little cause for joy with existing bond investment, but are ultimately the flip-side of the previous good returns over the past decade and the sustained period of ultra-low yields. Looking to the future, this opens up earnings potential that bond investors have yearned for for many years but that was nowhere to be found for more than a decade. Put simply, the markets are currently attempting to price in conditions where they will be left to their own devices, with no massive, direct and sustained market interventions by the ECB. Right now, they are primarily caught between inflation and recession risks on the one hand and less support from the monetary policy side on the other. In fundamental terms, the currently still very good situation (interest rate coverage, debt levels, earnings, cash flows, extremely low default rates) will likely deteriorate in the coming quarters. At the same time, the European credit markets have priced a great deal in, including a mild recession scenario. In this context, it is important to note that a substantial portion of the yield increase and spread widening is due less to worsening credit quality of the individual issuers than to the changed inflation and central bank environment and the capital flows (for example, retail investors have been conducting a great deal of selling recently). The rating migration is still positive. And there is no panic to be seen on the markets – neither among investors nor issuers. One positive factor from the investor perspective is the fact that attractive new issue premiums are again being offered.
Current fund positioning
Under these conditions, the fund management has generally positioned the fund in medium terms (5 to 7 years) and good credit qualities. The short maturities are still felt to be too expensive at present, as are the lower quality segments in the investment grade universe. Single-A ratings are thus felt to be the better choice over BBB rated bonds from a risk-return perspective. In addition, bonds from financial institutions also appear to be very attractive based on risk-return aspects. Thus, their allocation is currently close to the maximum possible level of 20% of the fund assets.
Further spread widening and yield increases as well as rising default rates are certainly possible (the latter practically unavoidable, in fact). But the achievable yields are now providing good compensation for these risks. Risks that are certainly not fully priced in include further and sustained geopolitical escalation and/or a deep recession, or further unexpected increases in inflation. None of this can be ruled out, but such developments are not included in our base scenario. On the other hand, decreasing inflation, a compromise in Ukraine, and/or at least a partial reduction in tensions and sanctions could also lead to more positive scenarios than the market is currently pricing in.
Volatility will surely persist for the foreseeable future, though this must also be kept in perspective: What now seem to be unusually high fluctuations were more or less normal up to ten years ago, until they were displaced by a period of extremely and in part artificially low (central bank interventions) volatility. The latter seem to be over for the time being. At the same time, the elevated risk of price volatility also offers better opportunities for active management. With that in mind, the fund management is looking to the coming years with optimism despite the current challenging market situation.
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* ESG stands for environment (E), social (S) and corporate governance (G).
** The Sustainable Finance Disclosure Regulation (SFDR) is an EU regulation on the disclosure requirements in the financial services sector regarding the consideration of sustainability criteria in its processes and products. SFDR Art. 8: The fund takes environmental and/or social criteria into consideration for investment.