Invesco Euro Short-Term Bond Strategy Insights

The last quarter of the year was marked by the announcement of three Covid-19 vaccines and the expectation of a roll out in 2021 which fuelled hopes for a medium-term global economic recovery.

The end might be in sight, but the present reality is still challenging as infection rates continue to rise and the emergence of a new variant rattled the markets by year end.

This led to full lockdowns across several countries in Europe including the UK; the respective central banks responded with additional support.

Lastly, a Brexit deal was finally reached after many rounds of negotiations and just before the end of the agreed transition period on the 31^st of December. The removal of this very real tail risk event was a material positive for risk markets.

2020 Summary

• 2020 began in line with expectations with uneventful government bond markets and a slow grind tighter for credit off the back of a strong 2019. This relative calm abruptly ended when March arrived with the onset of the global Pandemic. The first quarter of 2020 will be remembered by several unwelcome records relating to unprecedented moves within financial markets.
• During this time the strategy prioritised liquidity to ensure we were not forced sellers into an illiquid and volatile market, this was successfully achieved as we maintained good levels of cash throughout. In addition, more conservative positioning going into the crisis combined well with hedges (both through duration and credit) to help reduce drawdown in the strategy during the uncertainty.
• Given the strategy’s overweight to investment grade rated corporate bonds, once markets began functioning more normally in April post the intervention of Central Banks globally, the strategy performed extremely well as credit markets rebounded strongly through the remainder of the year. In addition, early on in this recovery phase we also selectively added to credit risk in our most favoured themes and names as we sought to capitalised on the attractive valuations created by the Pandemic and high levels of primary issuance.
• Performance throughout the year was further aided by the strategy’s preference for longer dated government bonds (5 year part of the yield curve) versus the short end (2 year part of the yield curve) given the positive yield pickup they offer against a backdrop of negative short end interest rates. This additional carry was partially eroded throughout the year as government yield curves flattened, which also benefitted the strategy’s relative performance versus the benchmark.

Strategy

In terms of positioning, we continue to maintain a preference to investment grade corporate bonds versus government and securitised bonds. Despite European corporate bonds retracing the vast majority of their Covid-19 spread widening, we still believe they offer attractive carry versus government bonds. For example, all European government bonds out to 5 years of maturity dipped into negative yields which present limited incremental upside in our opinion.

Hence, we prefer to deploy risk capital to high quality corporates whilst enhancing the yield profile of the strategy. Given this, the strategy is carrying positively (around 45bps) versus the benchmark, delivering a flat gross yield versus the -45bps of the benchmark.

Within the corporate bond allocation, we remain cautious on sectors with significant pandemic exposure (cyclical firms and travel and leisure industries) given lingering demand concerns which could be exacerbated by the second wave.

However, given the short-dated nature of the strategy (greater visibility of cashflows within our investment horizon) we may seek to capitalise on any dislocations where our credit research team are positive on specific names and we see value. In addition, we continue to see attractive pockets of value in the more resilient sectors as well as the primary issuance market.

We expect technicals to remain supportive of corporate spreads in European credit markets. The ECB is currently buying up to €10 billion of corporate bonds per month, equating to just over 1% of the eligible index. Meanwhile, new issue supply should slow down on a year on year basis which will provide ongoing support for the market.

Additionally, in Europe, balance-sheet preservation trends remain positive. Therefore, we believe that Europe is now firmly in an early credit cycle phase, where the focus of CFO activity will continue to be on reducing costs, increasing cashflow and reducing leverage rather than focusing on shareholder friendly activity; hence the medium term corporate fundamental picture remains positive in our opinion.

Given this, we believe that risks of a material re-widening in credit spreads remains low, hence the asset class remains one that can benefit as a carry type play especially with interest rates (nominal and real) so low.

The overall risk of the strategy, as measured by ex-ante tracking error, continued to fall during the fourth quarter.

This is being primarily driven by a reduction in market volatility, despite a jump in October after the onset of the second wave was apparent, rather than changes to positioning. Where we have altered the positioning in the strategy , we have used the primary market to add very high-quality corporates at attractive levels.

Here, we have also used the US credit market to add names which offer value on a currency hedged basis. Non-euro denominated bonds owned in the strategy  have increased from 3% at the beginning of the year to around 6.5% today, split around two thirds to US dollar denominated debt and a third to sterling (all holdings are currency hedged).

Currently the strategy  is around 24% overweight versus the benchmark in Corporate bonds (on a market value % basis), whilst spread duration remains around 2.4 years. The strategy  continues to deliver its attractive yield profile whilst maintaining a very high average credit quality of A-.

In terms of interest rate duration, the strategy  is in line with the benchmark at 2.0 years. Despite core duration being less appealing at current valuations, we believe rates are well anchored by the ECB, inflation remains extremely weak and we continue to view duration as the most effective hedge to the credit Beta of the strategy  should sentiment deteriorate.

Indeed, whilst a rebound in global growth is our base case for 2021 through the easing of lockdown restrictions in the second half of the year, a return to pre-pandemic GDP levels is not anticipated until at least 2022 across North America and Europe. Therefore, we remain convicted that financial repression/secular stagnation will continue to keep core European interest rates range bound for the foreseeable future.

Within peripheral government bonds, we believe the main driver of the market will continue to be the ECB given the quantum of asset purchases completed and the flexibility afforded under the current PEPP programme.

As such we have a small overweight position in Italy versus a short in France and Germany as we see some room for spread compression in the current hunt for yield environment.

Overall, we believe the strategy  remains well positioned to deliver compelling risk adjusted returns in the current environment.