In December 2022 Professional Pensions held a webinar in association with Aegon Asset Management to discuss net zero in fixed income.
The webinar panel - which comprised Aegon Asset Management head of credit UK Iain Buckle, fixed income investment manager Rory Sandilands and responsible investment specialist Ritchie Thomson - looked at the frameworks and approaches fixed income investors are taking when incorporating climate change in their portfolios.
The panel, chaired by Professional Pensions editor Jonathan Stapleton, also talked about how short-dated bonds can help meet climate objectives while delivering outcomes for investors.
Listen to the webinar in full here.
Why is climate change an increasingly important theme within fixed income and how can we incorporate it within portfolios?
Iain Buckle: Significant action is required to reduce our greenhouse gas (GHG) emissions throughout the world. We expect the scrutiny by regulators and underlying pension scheme members of climate-related exposures to only increase. From an investment perspective, companies most poorly aligned with that transition will gradually underperform those better aligned. How do we go about determining whether a company is well aligned with the transition to net zero? Over the last 12 months we have been working with our responsible investing team to build a forward-looking framework that will evaluate a company's alignment with the transition to net zero.
What does that process look like? Every company gets a base assessment of its climate-transition readiness by looking at three things: any ambitions or targets with regard to GHG emission reductions, their current level of GHG emissions, and overall management policies towards climate transition. Then we categorise every company using a 1-5 scale from leaders to laggards - respectively those that are ready for a low-carbon future and those that are not. This can be used across different asset classes but so far we have implemented this analysis into a global short-dated investment grade bond portfolio.
Why is now a good time to invest specifically in short-dated investment grade bonds?
Rory Sandilands: 2022 saw a significant move higher in base rates around the globe, as central banks sought to tame inflation and bring it under control. This is reflected in the dramatic shift higher in yields.
Turning more specifically to the opportunity in credit, incremental yield remains available in high-quality investment grade bonds compared to underlying risk-free assets. Credit spreads increased over this period - reflecting both the increase in underlying interest rate volatility we have seen in 2022, and the deteriorating economic outlook and its potential for the impact on company balance sheets.
While such risks warrant close monitoring, investment grade credit fundamentals are in relatively good shape and we expect companies to be able to manage their balance sheets and liquidity appropriately.
What in your view makes a company's transition plan credible?
Ritchie Thomson: Most companies are at relatively early stages of transition planning. We have seen more companies now beginning to make commitments to emission reduction targets. Although transition plans need to go well beyond emission reduction targets, they also act as a good first step to assess whether the plan itself is robust and credible. The plan can only really be credible if the target itself is ambitious enough.
On the target-setting piece of the strategy, what we first like to see from a credibility perspective is long-term commitment to net zero, but also robust targets set, more in the short to medium term. It is important that we see deep reductions in emissions over the next decade if we are to meet the goals of the Paris Agreement.
Are there any unique considerations for fixed income investors when integrating climate change into portfolios?
Iain Buckle: Investment grade fixed income is dominated by financial companies. Although they typically have very low carbon footprints, they obviously play a very important role in financing sectors that may be exposed to climate risks. Understanding the financials and what they are doing regarding climate change is very important for fixed income. That is why we include the major financial sectors in our high-influence sectors.
Data quality in investment grade is pretty good, but as you get down into other parts of fixed income, such as high yield and emerging markets, it starts to be less reliable. It is not like listed equity, where the level of disclosure is always very high.
Engagement can also be a challenge as a bond investor, and we need to look closely at how we engage with companies on climate transition matters. We would very much like to be in a position whereby we can engage direct from the portfolio if that makes sense on companies that rate poorly. We would like to develop that into more of a two-way conversation around asking them to provide the direction of the business and us being able to perhaps criticise on areas where we find shortcomings.
Looking at specific emissions and scope 1, 2, 3 emissions, how do you think about those in your portfolio?
Ritchie Thomson: We look at scope 1 and 2 emissions for every issuer, essentially to check they are included within the base assessments, where we look at target setting and emissions performance. With Scope 3 emissions, which are far broader, things become more dispersed when it comes to coverage. Where scope 3 emissions are the key issue for a company in terms of materiality and that issue can reduce those emissions, we focus on scope 3 emissions as the key issue there. We then take a deep dive in terms of the targets. Have they set scope 3 targets and are they looking at the right thing? Is strategy aligned to those scope 3 targets?
What is your outlook for fixed income risks?
Rory Sandilands: We see two key risks - inflation, and a potentially much deeper recession.
With respect to the inflation picture, if higher inflation does transpire from here and persist, it will force central banks to raise rates further beyond current market pricing. A modest rise, around the 4.5% in the UK base rate, would not necessarily be challenging. However, something much more significant would certainly challenge the thesis of how constructive we are around the front end of the market.
With the recessionary outlook, we anticipate a marked downturn next year, but not perhaps something to really threaten the investment grade space. We are not overly concerned about recession risks from an investment grade perspective, largely because most companies are in a pretty robust place going into this period.
While we are keenly monitoring these risks, our view remains constructive on this part of the market for 2023.
This webinar was held on 6 December 2022 in association with Aegon Asset Management. Listen to the discussion in full here.
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