See the wood, not just the trees

Climate-themed IG investing can take several forms. Some can be passive, through a green bond or PAB. Other approaches apply a climate lens to the whole IG universe, which requires bottom-up selection and active management. The latter can offer climate-risk mitigation through investment in transition-oriented companies and firms offering climate solutions.

Investments in passive indices can allow investors to easily tick a regulatory box and decarbonise their portfolio; but they have serious limitations. PABs achieve lower carbon intensity in portfolios by excluding the highest greenhouse gas emitters and reallocating capital to low-impact sectors. Therefore, they tend to leave out huge swathes of the IG credit market. For example, the MSCI Paris-Aligned Benchmark index has 11,367 constituents, versus 16,230 for the Bloomberg Global Aggregate Corporate index.⁴ Some solutions providers also have a high carbon footprint, particularly in their “Scope 3” emissions (indirect emissions that result from the company’s broader value chain), and may be excluded despite helping other businesses reduce their carbon load.

From a credit investor’s perspective, this narrows the pool of investable securities. It also limits support for companies whose transition is vital if the economy as a whole is to achieve a lower-carbon future. It does not incentivise businesses starting from an environmental low point to change and could deny them cheaper capital to invest in the transition. Yet virtually all companies will be impacted by climate change, through physical climate risk or when regulation and customer and shareholder pressure force them to decarbonise their operations and supply chains. They will need to adapt, so simply ruling out high-carbon emitters or investing in green bonds will not deliver the transition.

Similarly, green bonds comprise a relatively small investment universe, despite growth in this market over recent years (they made up c. 15 per cent of total issuance in 2023).⁵ Therefore, green bond funds can restrict the available opportunities for return and diversification, diverge from core IG funds in terms of their return profile and potentially introduce concentration risk.

In addition, green bonds typically only apply to a small part of a company’s capital expenditure, allowing for higher emissions on the rest of its operations. This also means they tend to be smaller issues, as the use of proceeds must be identified and allocated, which is a more onerous process than for general purpose bonds. However, as capital and interest payments are fungible with the issuer’s traditional bonds, the green bonds may not be as environmentally friendly as they first appear. Looking at the underlying company is key, rather than just the use of proceeds of a particular bond.

Many green bonds also have a lower spread – and thus a lower yield – than comparable “vanilla” bonds. This is the green premium, or “greenium”. And they tend to trade less frequently, since green bond funds can be wary of selling the green bonds they hold, for fear of not being able to redeploy their cash. That makes green bonds less liquid than vanilla ones, making it more difficult for investors to manage their risk exposure actively.

The growing climate threats facing issuers and bondholders, including stranded assets and physical and transition risks, like regulatory fines or changes in consumer preferences, should also be taken into account. Climate risk is often underappreciated by credit investors, but it encompasses the long-term effects of climate change on a company’s operations and business model. As such, it should play an important part in any assessment of an issuer’s creditworthiness.

Meanwhile, indices tend to rely on backward-looking metrics, with corporate climate reporting often lagging or incomplete. As a result, benchmarks that only include low-carbon companies are not necessarily inherently sustainable. For example, in January 2023, over 120 passive funds, mostly tracking PABs and climate-transition benchmarks, downgraded from Article 9 (products that have a sustainable investment objective) to Article 8 (funds that promote “environmental and/or social characteristics”) under the Sustainable Finance Disclosure Regulation (this applies to entities established and marketed in the EU, and does not apply directly in the UK).^6,7

And passive approaches that replicate these benchmarks offer limited protection to investors from climate risk, as they do not take investee companies’ transition and adaptation plans into account. While PAB companies may offer a lower carbon footprint in portfolios today, not many more than in the broader market are on track for future warming of less than two degrees (see Figure 1).

Achieving real-world change requires tackling the highest-emitting sectors, encouraging companies to transition to greener business models and influencing the cost of capital of true leaders and laggards based on their transition plans.

Active strategies can use bottom-up analysis and security selection to invest in solutions providers and transition leaders – companies that are improving their resilience to climate change – across sectors. That creates a broader opportunity set while mitigating exposure to climate risk and supporting the real-world transition. Such an approach can be forward-looking, by focusing on issuers’ commitments through initiatives like Science-Based Targets. For example, our Climate Transition Global Credit strategy has highly selective investments in North American utilities because they are further behind on transition planning than European peers.

In parallel with a robust climate-transition approach, broad-based, active, climate-aware strategies can be designed to have all the portfolio characteristics and use the same portfolio construction methodology as core IG, with significant potential risk and return benefits.

This type of approach can allow investors to take climate considerations into account in their core IG allocation, rather than as a niche or thematic investment, because harnessing a broader universe allows such strategies to deliver performance and lower volatility in line with broad IG credit strategies. And it allows for easier like-for-like comparisons across IG managers.

For instance, it gives investors more arbitrage opportunities, and allows them to harness such characteristics as new issue premia and to avoid the more expensive parts of the secondary market. We are seeing more dispersion between issuers in 2024 (see Figure 2), which should create opportunities to outperform through fundamental analysis, security selection and robust portfolio construction.

Figure 2: Spread dispersion within the credit universe

Source: Aviva Investors, Bloomberg, BoAML Global investment-grade index. Data as of March 31, 2024.

Active investing enables such robust portfolio construction approaches, which we use across our global investment-grade strategies. Importantly, given the asymmetric nature of fixed income, they prioritise downside protection. Disciplined portfolio construction can also generate alpha (excess return achieved over the relevant benchmark, rather than beta, which captures the direction of the overall market), leading to more consistent outperformance through the cycle. Our portfolio construction approach follows three core investment beliefs: avoiding a beta bias, portfolio optimisation and an alternative approach to allocating risk.

We avoid beta biases, as these can lead analysts to favour lower-quality or even off-benchmark issuers that may struggle in volatile conditions. Then, our portfolio optimisation process aims to maximise portfolios’ expected excess return while maintaining the same level of volatility as the investment-grade benchmark. We use custom sectors to finely assess risk and volatility, run optimisations to identify the most efficient areas to allocate risk (see Figure 3), and define the optimal carry on bonds – which can help reduce a portfolio’s volatility without sacrificing returns (see Figure 4).

For example, Figure 3 shows that Comcast’s risk profile is far closer to Amazon’s than to Discovery’s, a seemingly similar company in the same sector. Therefore, switching from Comcast into Discovery gives an allocation an entirely different risk profile. While these are purely illustrative examples and not necessarily on bonds we own, they show how such analysis can help investors identify higher and lower risk-adjusted returns in companies within the same sector.

Meanwhile, owning riskier carry at the front end of the curve and higher-quality carry at the long end tends to be the most efficient way to reduce volatility in the portfolio without giving up expected returns (see Figure 4). It typically provides downside protection during periods of market stress, while the excess carry collected at the front end of the curve bolsters performance.

This approach creates a structural allocation of risk that avoids beta biases and means investment ideas must prove their mettle – only the best ones get included in portfolios.

Finally, active investing can help investors mitigate the risk of exposure to stranded assets, not just through the normal IG work of investing in companies with strong and stable balance sheets, but also through bottom-up assessments of issuers’ climate risk exposure and transition plans. A 2024 study by the Potsdam Institute for Climate Impact Research found that global annual damages from warming temperatures and changes in weather patterns are estimated to be $38 trillion, with a likely range of $19-59 trillion in 2050.⁸

Some companies are ill-prepared for change, which will increase the risk of damage, through lack of adaptation, as well as the danger of seeing their assets stranded as tougher regulation comes in. If they must make wholesale adjustments and dispose of significant assets over a short timeframe, it could impair their balance sheets and increase their cost of capital. That is likely to be far costlier than well-planned, incremental change.

Thorough issuer analysis can identify those dangers early on, allowing investors to take steps to mitigate their risk of exposure. As a result, they can favour companies whose transition models are first class. Even better, some firms with ambitious climate commitments purchase dirtier companies and improve their environmental footprint. For instance, T-Mobile stuck to its ambitious Science-Based Targets after acquiring Sprint in 2020, and in 2023 announced a net-zero target by 2040 across its Scope 1, 2 and 3 emissions.^9,10

Using a broad investment universe can allow investors to benefit from a core global IG approach with robust portfolio construction and long-term risk and return benefits. But it can also enable them to help drive real-world change beyond achieving net zero for their portfolios alone. Looking beyond passive green bond funds and PABs can help investors see the whole wood, and not just the trees.