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By shifting the focus from solely following a principles-based approach to one that emphasises the environmental outcome, a previously unappealing asset class can be opened up, allowing the environment to play a core role within a balanced bond portfolio.
The conventional investor approach to climate change has focussed on managing risks around ‘stranded assets’. Companies that own potentially stranded assets can be screened out by investors or, indeed, divested.
This approach uses negative reinforcement to discourage environmentally unfriendly projects, but crucially it offers no reward for bond issuers considering more environmentally responsible undertakings. That’s where green bonds come in. Green bonds provide financing for projects which deliver environmental benefits and contribute to a more sustainable economy. This positive reinforcement is its key advantage. But it suffers from two important drawbacks:
- There is no universally agreed standard for what a green bond is.
- The green bond universe offers only low yields and spreads (chart 2), especially when compared to a broader global credit portfolio.
Source: Climate Bonds Initiative, 31 July 2018
Source: Fidelity International, BAML, 31 July 2018
Source: ICE BofAML Green Bond index, CBI, 31 July 2018
Source: CBI, 31 July 2018
What defines a green bond? Several independent organisations have published guidelines for green bond issuers that promote transparency. However, in theory anyone can issue a bond and call it green. This risks undermining confidence in the asset class.
The Green Bond Principles published in 2014 formalised World Bank standards but only on a voluntary basis, and within the principles there is wide scope for interpretation. In 2017, nearly a quarter of green bonds did not have an external review.
What the market needs is a common language around common tools, and agreed ‘greenness’ thresholds, benchmarks and impact measurement. Unfortunately, the proliferation of approved third-party verifiers makes this unlikely. Another consideration is that standardisation shouldn’t stifle the innovation the market will need to continue fostering.
Green bond issuance is expected to grow from the record US$161 billion in 2017 to US$250 billion in 2018, with more issuers coming to the market. The green bond universe remains strongly influenced by government entities, which have contributed over half the outstanding issuance. Because they can issue bonds cheaply, it depresses yields and spreads for the green bond universe compared to the broader credit market.
In a low-yield environment, many investors can’t ignore even a minor ‘greenium’ (a green bond premium that reduces the yield for investors but provides cheaper funding for issuers). It could preclude green bonds as a core portfolio holding.
It’s a paradox for the market. Cheap funding encourages issuers to pursue green projects, benefiting society, but those low yields keep some investors at bay.
Some sort of selective credit enhancement, including guarantees, subordinated debt and insurance, could be part of the solution. This would boost the credit rating of the bonds, potentially improving the risk-return profile for investors.
The market’s limited liquidity poses a similar challenge. Although it’s not a problem in the Sovereigns, Supranationals and Agencies (SSA) sub-sector, it does matter in the corporate market, where investors tend to buy and hold the longer-dated issues. This is exacerbated by:
- Weak US involvement - there is little participation by US corporates and government bodies. While the market is viable without the US, the absence of American issuance significantly reduces the long-term growth potential of green bonds.
- The myopic definition of green bonds; in addition to the ambiguity of what a green bond is, the definition also ignores the broader range of ‘environmentally aware’ schemes. The Climate Bonds Initiative (CBI) estimates that including ‘climate-aligned’ bonds would boost the size of the universe from US$221 billion to a whopping US$895 billion. In any case, the CBI definition of climate-aligned bonds suffers from the same fuzziness around standards that green bonds do.
The grass can be greener
While the green bond market goes through growing pains, we think there is a solution for investors that enhance both the environmental impact and the potential return. That solution involves shifting the emphasis to carbon reduction, accentuating the environmental outcome rather than solely focussing on the principles-based approach of green bonds.
If green bonds are supplemented by low-carbon bonds, the investable universe grows dramatically, with many benefits:
- Negative and positive reinforcement: Green bonds provide positive reinforcement by acting as an incentive for issuers to pursue green projects. Low carbon bonds discriminate against less environmentally-friendly issuers, acting as negative reinforcement.
- Quantifiable metrics of green credentials: A carbon reduction mandate creates a clear, objective target. It’s possible, through intensive analysis, to measure and quantifiably reduce carbon production.
- Mirroring global corporate bond characteristics: It is possible to create portfolios that preserve carbon reduction goals and still mimic the risk profile of a global corporate bond index, using fundamental portfolio management techniques.
Low carbon bonds: A three-stage investment process
STEP 1: Define the universe - green bonds plus low-carbon emitters
To create such a portfolio, the first step is to combine negative screening of stranded carbon assets with positive screening based on environmental awareness. The universe is formed of those companies which are already low emitters or have transition plans towards that goal.
Issuers within each sector are ranked on emissions. The lower ranked issuers (higher emissions), are tested to see whether they have credible transition plans to a low-carbon world. Issuers which are high emitters and have no plans to transition are discarded from the universe.
STEP 2: Apply active overlay
Investing for climate change requires an active approach because third-party data is of limited use. Although third-parties can provide a good starting point, their data needs to be adjusted for differences in business models, accounting standards and product pricing. Additionally, engaging with senior management helps to better understand corporate transition plans, their impact on emissions and the plausibility of their claims, so that weak plans can be excluded from the investment universe.
Active security selection can also augment returns by minimising losses caused by downgrades and defaults. Fundamental credit analysis can filter out the weaker issuers to make the portfolio more robust.
STEP 3: Optimise the portfolio
Next, the portfolio needs to be managed for yield, duration and credit rating to replicate the key risk characteristics of a global corporate bond index. Sector, country and issuer constraints can all be built in. Optimisation ensures a minimum level of issuer diversification, while position sizing scales based on credit risk. Liquidity considerations can also be incorporated.
This approach preserves the risk and return characteristics of the global credit universe. The low-carbon model portfolio has higher yields and spreads, and longer duration than the green bond index while maintaining investment grade credit ratings (table 1). The solution’s attributes are comparable to global corporate bond indices.
Note: ICE BofAML Global Corporate Bond ex-Energy index is a proxy for a divestment strategy Source: Fidelity International, BAML, 31 July 2018
Interest in green bonds is on the rise, but the market is challenged by a lack of standardisation, low yields and liquidity constraints. Low costs may attract issuers, but they also deter investors, making the environmental benefits hard to realise.
Shifting to a two-degree scenario (2DS) path can only come from driving change in traditionally high emission sectors. This requires targeted investment in companies at the forefront of adapting to a low carbon future. Simply excluding carbon intensive sectors only reduces the competition for assets, increasing returns to ‘non-environmentally aware’ investors.
Investing in green bonds is an important component of 2DS. Green bonds currently represent only a small exposure in the global corporate bond universe but it’s expected to continue its strong growth to become a vital source of funding for the 2DS. Actively overweighting green bonds positively reinforces the shift towards energy efficiency and greater use of renewable energy sources. But this requires a hands-on approach to carefully appraise the green credentials of each security and avoid green washing.
The potential of the green bond market can be unlocked by shifting emphasis from a principles-based method to one which focusses on the environmental outcome of carbon reduction. By leveraging the equity market’s superior disclosures, and mapping that information to the bond market, we can create a broader, but more quantifiable, universe of ‘green’ fixed income investments. This universe can then be enhanced with an active overlay and portfolio optimisation to deliver performance competitive with the wider corporate bond market.
Environmentally aware investors don’t have to be penalised in the performance of their bond portfolios. With this approach three-stage investment process, ESG mandates can be respected and environmentally friendly investment can become a viable core strategy within a balanced bond portfolio.
 24% of issuance did not have an external review, Climate Bonds Initiative, Q1-18 Summary.
 CBI estimate, State of the Market 2017.