We speak to Shyam Gharial, sustainable investing researcher at LCP, on a big research project he’s been doing, looking at setting up corporate bond mandates with sustainability criteria. It aims to tilt portfolios away from companies with bonds most exposed to sustainability-related risks. This has had some interesting results and is particularly relevant for DB pension schemes.
With many defined benefit pension schemes reducing their equity allocations, they may well find their biggest climate exposures in their bond portfolios over the next 10 years. How are bond managers looking at climate risks and transition risks and how can portfolios be set up to better align with sustainability criteria?
We discuss
Increasingly sustainability is being recognised as something that has been neglected in managing investments and companies, and this has led to systemic risks. Climate change is one of these but not the only one. It also includes biodiversity loss, water risk, natural habitats as well as broader social factors impacting communities and particular segments of populations.
Aligning equity mandates with sustainability criteria has become a very popular thing to do and a relatively well-trodden area with many funds and indices launched, but bonds remains less so.
Many investors – but particularly UK defined benefit pension schemes – hold increasingly large portfolios of high-quality corporate bonds. These are expected to be paid back over the next 20 years or more which make them very sensitive to longer-term emerging risks such as these sustainability issues.
The most obvious ones are climate related, eg stranded fossil fuel assets and/or sharp changes of regulation to meet climate targets that have far-reaching impacts on particular sectors (or companies within a sector that have not addressed the issue strategically).
These criteria can be incorporated into bond portfolios such that the bonds selected are better aligned with the low-carbon transition, or with broader sustainability fundamentals meaning they are less at risk.
Managers incorporate these criteria in a number of ways but many use proprietary models to assess future climate-alignment and bring together a range of sustainability factors together into a portfolio management tool.
This is different to investment in green bonds or social bonds. What we’re talking about here is often what’s called “unlabelled” bonds, ie the general universe of bonds issued by companies and we are talking about sorting this universe in specific ways to align the portfolio with certain risk factors.
More detail in LCP’s blog here
One thing to takeaway
You can tilt your bond portfolio to focus on more sustainability aligned companies without compromising yield.
Most underappreciated thing
That the investment industry doesn’t exist in isolation in a silo. It’s part of the broader world and broader factors should be incorporate outside just returns.
