Climate Transition Opportunity In Fixed Income

How did the fund perform in Q2? What worked well and what didn’t?

Henrietta Pacquement: Politics stole the show over central banks in the second quarter. With half the world population voting in 2024, we always knew that the electoral cycle was something to watch throughout the year and it didn't disappoint in Q2. We even got an extra unexpected legislative election in France, which provided one of the more interesting market moves in the investment grade space during what was largely an uneventful period for the asset class. In that context, the fact that the European Central Bank (ECB) cut rates went almost unnoticed as it was well flagged. The ECB is now the second major developed market central bank to do so, signaling that they believe inflation is coming under control. We expect rates to remain rangebound around current levels for the rest of the year. So, how did that play out in our portfolio? Over the quarter, the Climate Transition Global Investment Grade Credit Fund I Share Class was marginally behind its benchmark on a net basis by 7 basis points and in line on a gross basis. This is reflective of the fund's risk profile that is close to benchmark from a macro perspective, given current attractive overall yield levels and lower than average credit spreads. That translates into a duration close to 6, a continued tilt to financials, though, that has been reducing over time and then underweight to more cyclical sectors. A modest underweight to French assets pre-election offered space to add through the modest volatility patch experience in June. In particular, EDF chose to issue post the first round of the elections and had to come at 200 basis points for their 20-year offering in which we participated, subsequently harvesting 20 basis points running of spread performance. From a bottom up perspective, we continue to see a broadening of climate-related funding initiatives. A recent example harnesses technology infrastructure development with home heating. Microsoft is developing data hyper-centers in the Nordics and collaborating with local utilities to harvest waste heat to use in district heating networks. We think this ecosystem approach is key to managing the transition in years to come and will deliver financial results for investors.

We have seen increased interest from investors seeking climate transition fixed income strategies. Why do you think that is?

Henrietta Pacquement: We continue to see a positive evolution in how investors are tackling the climate question in fixed income. Lessons learned over the last few years are translating into more sophisticated approaches that should see more allocations to this space in the short to medium term. Two trends we think are of particular interest are continuing to emerge. The first is an increasing understanding that the focus needs to be on facilitating the transition of the real economy rather than just decarbonizing portfolios and using exclusions. It's been great to see this trend being reinforced in the Net Zero Investment Framework 2.0 guidance that was published by the Institutional Investors Group on Climate Change in late June. The second is that there's an increasing understanding of the engagement opportunities in the fixed income space, given the asset class’s unique specificities. Fixed income investors have frequent and natural touchpoints to express their views and convey expectations from a climate perspective through the new issue processes, for instance. These are useful feedback aggregation points for the companies themselves to track their sustainability progress and home their climate strategies. These trends align with Allspring's Climate Transition Credit approach, which we launched over three years ago now and has reached some $5 billion in assets under management.

The fund I share class (USD) returned 1.22% in the second quarter. What worked well and what didn’t?

Sarah Harrison: The global high yield market continues to do what it does best and chug along and earn carry. Two non-consensus calls have worked well for us this year. Firstly, an overweight cyclicals and underweight to non-cyclicals. Our view has been that the strength of the consumer, particularly in the U.S., would keep top line for corporates strong, which is positive for cyclicals. Conversely, we believe that corporates would struggle and did struggle in situations in which they had high interest burdens and unsustainable capital structures, which tends to be in the non-cyclical space. Also in our favor, our overweight to Europe versus the U.S. contributed as we saw the ECB (European Central Bank) cut before the Fed (Federal Reserve) in June. An underweight to the stressed part of the market worked less well, but we believe that discipline and security selection will pay off in the long run.

The fund reached its one-year anniversary in June. What did you learn in the first year?

Sarah Harrison: Climate transition is a relatively new concept for the high yield market, so this year has been full of learning. Our main takeaway from a climate perspective is that the view on what is right is evolving and you need to stay on top of the evolution. It certainly helps to be supported by the 15 strong Sustainability team we have here at Allspring. The main takeaway from a financial perspective is that you absolutely can generate competitive performance for traditional high yield funds while investing in this style. Outside of climate transition, market events have reinforced three key lessons learned over the team's average of 22 years of experience. Firstly, avoiding losers is just as important as picking winners. Secondly, high yield portfolio managers are risk managers as well as investors. And finally, paying careful attention to corporate governance can help to avoid defaults.

High yield looks attractive on a real yield basis while credit spreads remain relatively tight. How do you think about that as a portfolio manager and how do you view the market entry point?

Sarah Harrison: There's a great piece written by two of my Allspring colleagues called The Opportunity Cost of Waiting for Goldilocks that I urge you to check out. It's about market timing duration, but it very much applies to market timing fixed income generically. When thinking about allocating to high yield, carry is your friend in up markets and sideways markets and sometimes in down markets, as well. The Global High Yield Index, as of the end of Q2 2024, yielded over 7.5% in dollar terms. Every month that you delay a decision to invest to try to time the market costs you some of that running yield. If you're expecting a steep drawdown in the very near future, by all means, wait. But if your view is similar to ours and that default rates will remain manageable and credit spreads will remain rangebound, there's no time like the present.

Has the high yield market changed with the explosive growth of private credit?

Sarah Harrison: As investors know, there is a spectrum of liquidity in credit products and this is true even in leveraged credit. High yield sits on the liquid end of the spectrum and leveraged credit while private credit sits on the illiquid end of the spectrum. Bank loans are somewhere in the middle. In our view, high yield is complementary to private credit rather than in competition with it. The two are sufficiently different to be able to justify a position in both. Preference between the two boils down to, among other factors, how much do you value liquidity and at what level you value liquidity? If anything, the proliferation of private credit has, in our view, helped to keep default rates low as another source of capital for leveraged credits and has been a short-term positive for the high yield market technical.