High Yield: Becoming more sustainable
With effect from 1 July 2023, the sustainability characteristics of our unique and quality focused[1] Kempen (Lux) Euro High Yield Fund was considerably strengthened and aligned with the ESG approach of our Euro Sustainable Credit Strategy. The funds’ characteristics are now as follows:
i) Targeting a CO2 footprint that is at least 30% below the benchmark and declining by 7% per annum, thus strengthening our climate ambitions;
ii) Implementing stricter exclusion criteria, thus focusing more on “doing good”[2]; and
iii) Maintaining a minimum proportion of 20% of sustainable investments aligned with the EU Taxonomy, thus creating sustainable alpha.
The enhanced sustainability characteristics of and changes to our high yield fund are described in more detail below.
Climate ambitions
As investors we have an important role to play in facilitating the transition to a low carbon economy. Climate change is a key area of focus for us and we have defined objectives to be aligned with Paris Agreement goals. Accordingly, we have strengthened the ambitions of our high yield fund from targeting a CO2 footprint that is below the benchmark, to one that is at least 30% below the benchmark. The trajectory, a 7% annual carbon reduction on average, was maintained.
Graph 1: overall carbon intensity
Source: Van Lanschot Kempen, 31 December 2023
As of 31 December 2023, the Kempen (Lux) Euro High Yield Fund had an overall carbon intensity of 149 grams/EUR revenue, compared to 238 grams/EUR revenue, which is 37% below that of the benchmark.
In order to maintain a CO2 footprint that is 30% below the benchmark, we identify the 5% most pollutive companies within our universe. We are excluding those companies with no credible pathway to reduce CO2 emissions in line with the Paris Agreement.
Exclusions
In order to enhance our focus on “doing good”, the fund has implemented a stricter exclusion policy. This policy goes beyond the Van Lanschot Kempen firm-wide exclusion criteria to exclude additional business activities such as Alcohol, Gambling, (Un)conventional Oil and Gas and Weaponry. Companies that are CCC and B rated by MSCI are excluded, although investment in the latter is permitted on a comply and explain basis. As of 31 December 2023, more than 20% of our benchmark was excluded.
Graph 2: exclusions reduce investable universe by <20%
Source: Van Lanschot Kempen 2023, some percentages include double counting
Minimum proportion of sustainable investments
Making our high yield fund more sustainable also involved increasing the percentage of sustainable investments in our fund and committing to holding a minimum proportion of 20% of sustainable investments aligned with the EU Taxonomy. As of 31 December 2023 the percentage sustainable investments held within the Kempen (Lux) Euro High Yield Fund was at 23.2%.
Quality focus paid off in 2023
Looking back at 2023, the Kempen (Lux) Euro High Yield Fund outperformed the ICE BofA High Yield Composite Index (Q964) by 89 basis points over the twelve months ended 31 December 2023 (in EUR, gross of fees). This was despite applying stricter exclusion criteria during the second half of 2023. Our strong issuer selection more than offset the negative attribution from our conservative top down positioning. Our focus on BB rated companies with lower default risk exposure continued to deliver better risk-adjusted returns. We remained critical in our assessment of companies in primary markets, including those that issue green bonds, focusing on both fundamentals and use of proceeds. We managed to avoid investing in those companies that issued green bonds opportunistically to attract investors and were subsequently downgraded, such as Branicks Group and Graanul Invest. Since its launch in July 2017, the fund delivered annualised alpha of 1.2% (geometric, gross of fees) compared to the Q964 benchmark and 1.0% compared to the standard BofA ML BB-B High Yield Constrained Index.
Graph 3. Performance
2024 outlook
Current yields remain at relatively attractive levels. At the end of December yields on Euro high yield bonds were in excess of 5% and spreads over government bonds in the Eurozone were around 270 basis points. In our view the sharp drop in government bond yields during the last months of 2023 makes it unlikely that yields will decrease much further in the near term. Instead, we have seen widening recently with investors now more sceptical that the ECB will be cutting rates anytime soon.
Given the slowing macro-economic environment, we see downside risks from lower earnings growth and higher default rates. It remains considerably more expensive for businesses to refinance high yield bonds, which face significant maturity walls in 2024 and 2025. As a result, it is likely that spreads may widen from current levels.
Euro high yield have outperformed Euro investment grade in both 2022 and 2023, driven by higher coupons, lower duration and limited supply.[3] The jury is out whether 2024 will see a repeat of the previous two years. However, the shorter duration of the Euro high yield universe compared to Euro investment grade, bodes bodes well in the instance of further rates widening. If spreads remain range bound in 2024, Euro high yield is likely to outperform Euro investment grade yet again. A scenario of 100bps widening in spreads of the Q964 (ICE BofA High Yield Composite Index), more than the tightening seen in 2023, should still lead to a positive excess return in Euro high yield.
We have entered 2024 from a slightly cautious position. In beta terms we remain underweight, with positioning skewed to the higher quality names in the high yield universe and subordinated financials. We expect the European macro-economic environment to remain slightly weak and expect weakening in the US economy over the coming months. In our view the European Central Bank and the Federal Reserve are done hiking rates, but we expect the first rate cut to be later than what is priced in by the market.
Depending on market circumstances, we can act quickly to adjust our risk position. The technical picture may worsen during the year, as we approach the maturity wall. We do however expect that appetite for credit would be solid in a weakening macro-economic environment. The biggest risk we see at the moment is a hiccup in the downward inflation trajectory. This would push spreads wider. In a weakening macro-economic environment with expectations of more defaults, our focus on BB rated companies and those with stronger sustainability profiles are expected to outperform the broader high yield universe.
We have classified this product as class 3 out of 7, which is a medium risk class. Specific risks for investing in a high yield fund are credit risk, interest rate risk, currency risk and risks relating to derivative transactions. This rates the potential losses from future performance at a medium level.
[1] Combination of BB rated companies, subordinated bonds and subordinated financials (Tier 2 instruments) with investment grade credit profiles. Selective investment in B-rated companies is permitted but only based on strong conviction and/or upgrade potential. Strategy is managed against a custom benchmark: Q964 (ICE BofA High Yield Composite Index).
[2] In ‘’doing good’’ investments (one notch higher than ‘’avoid harm’’ investments), the goals is to build a sustainable portfolio for the client. The investment applies a best in class approach, with sustainability ambition translated into policy, implementation and reporting. Climate related ambitions are set. Higher thresholds of exclusion in areas such as animal welfare, labour and human rights and environmental harm are applied. Active ownership including a strong engagement and ambitious voting policy is expected.
[3] Return on the Bank of America Merrill Lynch Q964 index was +0.37% in 2022, compared to -5.15% on the iBoxx Euro Corporates. Return on the Bank of America Merrill Lynch Q964 index was 10.35% in 2023, compared to 8.18% on the iBoxx Euro Corporates.