by Bertrand Gacon, Lombard Odier
Many investors have decided to take on more credit risk as the duration in investment-grade bonds begins to look increasingly risky. We think that is a sensible strategy – but for those who cannot give up investment grade completely, a sophisticated climate bonds strategy offers a way to compensate low yields with positive environmental impact.
For 35 years investors looking for capital preservation and coupon income were able to meet those objectives with investment-grade bonds. Now, however, income investors face widespread low or negative yields in key developed markets and, if they have extended duration to find positive yields, heightened sensitivity to interest rates as well.
At Lombard Odier Investment Managers (LOIM), we think less constrained investors should venture a little further into credit risk rather than duration, and we feel that the “crossover” sectors – bonds rated BBB or BB – are an especially compelling alternative to investment grade.
Some investors cannot abandon investment grade completely, however. They have to accept low yields. But what if there was a way to make that capital work harder in another way? We would suggest that a portfolio of climate bonds can be constructed to mimic the return-and-risk characteristics of a broad investment grade allocation based on the Barclays Global Aggregate Index, while delivering additional positive environmental impact.
A growing market
The best-known part of the climate-bond market is the $160bn Green Bond universe. In December 2015, 223 countries signed up to an agreement to limit global climate change to 2⁰C above pre-industrial levels. The World Economic Forum, using International Energy Agency and OECD data, reckons that this requires an extra $700bn of investment, annually.
Green Bonds – issued to raise ring-fenced finance for projects that either mitigate or help the world adapt to the effects of climate change – were specifically designed to address that shortfall, and it was therefore no accident that the $81bn issued during 2016 almost doubled the $42bn put out the year before. This asset class is going mainstream.
Investment-grade ratings and yields, but not a perfect overlap
In many ways, however, it was always mainstream. The Green Bond innovation of ring-fencing proceeds represented the first opportunity for impact investors to go beyond their private market niches into large, listed household names among multilateral organisations, financials, utilities and multinational corporations. That profile also means the Green Bond market’s overall credit quality and yield look very similar to those of the broader investment-grade market, which is what makes it such a promising potential replacement for part of a core bonds portfolio.
However, investors thinking in these terms should be aware that the overlap is not perfect. Green Bonds’ currency exposure might differ from that of the Barclays Global Aggregate universe; maturities are on average slightly shorter; and they exhibit sector and regional tilts versus the broader market. Simply replicating a Green Bonds Index will not deliver equivalent exposures to the broader investment-grade market.
Nonetheless, constructing a portfolio from Green Bonds that does replicate those characteristics is eminently possible for an active manager – and expanding beyond labelled Green Bonds to include other “climate-aligned” bonds can further help manage these differences.
From Green Bonds to climate bonds
For example, there are non-labelled bonds issued by “pureplay” corporates that derive at least 95% of their revenues from climate-aligned business; bonds issued by corporates that derive substantial revenues from such business that are ringfenced but not labelled; and Social Bonds that help mitigate some of the effects of climate change. The Climate Bond Initiative reckons this universe is already worth almost $700bn, and we think it will reach $1 trillion within the next three years – giving traditional bond investors a much-enlarged toolkit to work with.
Clearly, going beyond Green Bonds can introduce as well as mitigate risks, assuming that one of the main reasons for including them in an investment-grade portfolio is to enhance its environmental impact. Non-labelled climate-aligned bonds do not offer the same enhanced transparency, monitoring and reporting protocols as Green Bonds, greatly increasing the potential to be misled by “greenwashing”.
Then again, at LOIM we find that 15% of labelled Green Bonds fail to meet our impact criteria. For example, on paper the €1.2bn Green Bond from French renewable energy and power company Engie, which finances renewable-energy and smart-meter projects with annual reporting on installed renewable capacity and energy-consumption reduction, looks perfect. However, one of its projects was a UK hydroelectric installation criticised for its negative impacts on the local freshwater ecology.1
In short, labelled or not, to maintain integrity while investing in these markets investors need a robust impact verification process that requires extensive resources, data and research capacity to establish selection and monitoring criteria for both bonds and their issuers. No credit portfolio manager worth her salt would buy a bond just because Moody’s or S&P had put a “BBB” label on it. Why behave differently in the climate bond market?
In a low-yield, high-risk environment for investment-grade fixed income, climate bonds could help make that part of your portfolio that cannot move further down the credit spectrum work a little harder. The Green Bonds market is a good place to start looking, but expanding the universe can make it easier to bring the return-and-risk profile in line with the broader investmentgrade benchmark, as well as ensuring you have the right bonds to meet your true impact objectives. An active approach based on a robust impact verification process is critical, but with a little additional effort a part of your portfolio that has become a challenge itself can become a part of the solution to one of the greatest challenges ever – the challenge of climate change.
1 Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document
FOR PROFESSIONAL INVESTOR USE ONLY. This material does not constitute an offer or solicitation in any jurisdiction where or to any person to whom it would be unauthorised or unlawful to do so. Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice. No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a financial promotion and has been approved by Lombard Odier Asset Management (Europe) Limited which is authorised and regulated by the Financial Conduct Authority. Past performance does not guarantee future results ©2017 LOIM. All rights reserved.
