Some environmentally conscious investors are currently being deterred by the green bond market’s lack of standardisation and uncompetitive returns. We think there is a way to address these concerns by targeting carbon reduction as well as green bonds so that negative screening techniques are combined with positive selection. This approach would make it possible to engineer green portfolios with better performance profiles than green bonds alone, and able to rival traditional investment grade corporate bonds.
Go green
The conventional approach to climate change is largely around screening out ‘stranded assets’ – assets that suffer unexpected or premature write-downs, primarily due to regulatory changes or technological innovation. This approach of negative reinforcement fails to offer any sort of reward to bond issuers considering more environmentally responsible undertakings.
Green bonds, on the other hand, provide financing for projects which deliver environmental benefits and contribute to a more sustainable economy. But this positive reinforcement suffers from three important drawbacks:
• There are no universally agreed standards for what a green bond is
• The universe has low yields and spreads because it remains strongly influenced by government entities which can issue bonds cheaply
• Liquidity is limited
The grass can be greener
By shifting the emphasis to carbon reduction – companies which are low carbon emitters or have transition plans towards that goal – it’s possible to enhance both the environmental impact and the potential return because the investable universe would grow dramatically. Other benefits include:
• Using both negative and positive reinforcement
• Generating metrics to quantifiably reduce carbon production
• Mirroring global corporate bond risk profiles while preserving carbon reduction goals
Low carbon bonds: A three-stage investment process
STEP 1: Define the universe
Green bonds plus low-carbon emitters (or companies transitioning towards that goal)
STEP 2: Apply active overlay
Because third-party data has various limitations, an active approach is required. Engaging with senior management helps investors understand the plausibility of corporate transition plans and the impact on emissions
STEP 3: Optimise the portfolio
The portfolio needs to be managed for yield, duration and credit rating to replicate the key risk characteristics of a global corporate bond index
The results
The low-carbon model portfolio has higher yields and spreads, and longer duration than the green bond index while maintaining investment grade credit ratings. In this way, ESG mandates can be respected and environmentally friendly investment can become a viable core strategy within a balanced bond portfolio.
By Ilia Chelomianski, associate investment director, fixed income and Adnan Siddique, institutional investment specialist, Fidelity International
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