19 January 2021
There’s never been a greater focus on the impact our investments have on the planet – and the influence that we wield as investors on the companies around us.
When it comes to measuring and managing the environmental impact of portfolios, equity holders often take most of the headlines. That's not surprising, shareholder resolutions are a powerful tool to shape business change, and the listed nature of the markets means data is more readily available and comparable.
But don’t forget about bonds – today many companies finance themselves substantially in the bond markets, returning regularly to raise money from fixed income investors. These investors have a voice, and potentially a strong one if they vote with their wallet, on the way these companies are run.
The question for us is, how can we set up more sustainable bond portfolios that work for our clients?
Investing in high-quality corporate bonds on a buy and maintain – rather than an active – basis makes sense. This has been our preferred approach for some time.
The beauty of buy and maintain lies in its simplicity. We ask managers to lend money to a range of investment-grade companies that they think will pay us back (with interest) over the long term. Don’t anchor to bond indices, just lend to companies with good credit characteristics. In doing this, we target a return over government bonds while providing certainty over future cashflows (so this portfolio can form part of any interest rate hedging programme for pension schemes). Clearly, it is not always as straightforward as it sounds – recent events provide an important reminder of the difficulties that companies can get into – but the aim is simple and eminently achievable for a good manager at low levels of fees.
These portfolios have a long investment time horizon: generally lending for ten, twenty years or longer. Given that, I see sustainability as a key consideration to manage the risks to your principal. Leaving ESG factors unmonitored can lead to exactly the kinds of issues we are aiming to avoid – tail risks which, if they materialise, can impact the viability and creditworthiness of a company.
Despite this, the absence of sustainable-labelled buy and maintain corporate bond strategies is notable. There are plenty of active corporate bond strategies that call themselves ‘sustainable’, ‘responsible’, ‘ESG’, ‘climate aware’ or that focus on green bonds – with varying degrees of success – but no similar buy and maintain corporate bond strategies.
Does this mean that buy and maintain mandates are ignoring ESG risks?
In my experience, corporate bond managers do consider ESG risks. This is primarily done case-by-case alongside other financial risks as part of the fundamental credit analysis (on a ‘bottom-up’ basis). As a result of investors’ increasing focus on issues such as climate risk, and the natural affinity between buy and maintain investing and sustainable investing, I believe that a further evolution in how buy and maintain corporate bond portfolios are run is warranted.
In my view, it is reasonable to ask managers to do more to manage these risks and give some further direction in terms of how best to structure these portfolios (from the ‘top-down’).
Where can I start to do more to allow for ESG risks?
There are lots of levers investors can pull to adjust mandate guidelines and to target sustainability characteristics explicitly. In particular, metrics are increasingly available (and robust) which allow investors to increase portfolio resilience to climate transition risk.
As a fairly simple first step, you can instruct an explicit reduction in greenhouse gas emissions of the portfolio. The financial argument for doing this is to steer the portfolio away from companies most responsible for emitting greenhouse gasses. Pressure on these companies is expected to come from various sources (including regulation, consumer behaviour and technology) as part of a coordinated global effort to decarbonise the economy.
Measuring greenhouse gas emissions of equities has become relatively commonplace. Many equity investors now manage their “carbon intensity” (ie tonnes of CO2 emissions per $m of sales). This is not as common in bonds as the data is not as readily available, but a good manager should be able to do it. We conducted research on over 50 portfolios which showed that a typical portfolio has a carbon intensity of around 190 t/$m, roughly comparable to an equity index such as the MSCI ACWI Index.
Bond investors can start by setting targets for this metric. And our research shows that you need not pay a huge cost in reduced yield to do so. Perhaps as little as 0.05% pa to reduce carbon intensity by 30% or more, while maintaining other key metrics such as credit quality and diversification.
The target reduction in greenhouse gases can be ratcheted up over time, with the objective of aligning to agreed long-term targets. Indeed, a number of asset managers have recently signed up to an initiative to work in partnership with asset owners on decarbonisation goals, consistent with the ambition to reach net zero emissions by 2050.
What about more sophisticated approaches?
Towards the more sophisticated end of the spectrum is the forward-looking temperature alignment of investment portfolios. Some managers can assess the extent to which a portfolio is aligned with the Paris Agreement target to keep temperature increases well below 2°C above pre-industrial levels. This can even be used to guide portfolio construction to explicitly target a temperature-alignment trajectory.
Beyond climate risk, some good examples we have seen incorporating wider sustainability factors include:
Investment frameworks linked to the UN Sustainable Development Goals – targeting companies with increased revenues to these areas.
Assessing societal or environmental externalities produced by companies and incorporating these into value assessments.
Using an independent advisory committee to police the sustainable universe separate from the investment case. This structure helps build credibility in managers’ assessment of the sustainability of companies.
Currently, climate metrics are better established and easier to codify than wider sustainability metrics – though there are (good and bad) ways to adjust portfolios looking at both. There are known limitations with some of the data available today and we expect the range of credible metrics will increase over time. The investment industry’s approach to sustainability is becoming more sophisticated and mainstream, and corporate sustainability reporting is also improving.
What should we be doing about this today?
I believe investors should be discussing this with managers now to ensure portfolios are appropriately managing ESG and climate change risk. Clear and achievable top-down sustainability guidelines (alongside strong, targeted engagement with underlying companies) are a good starting point for improving how these risks are managed.
I don't see sustainable buy and maintain corporate bond strategies as a new asset class but as an important evolution in how mandates are structured to be more resilient to ESG risks. If you are interested, the first step is to talk to your existing managers about what is possible – we would be happy to help you navigate this process.