investment viewpoints
3 years of TargetNetZero investment-grade credit
Credit convictions combined with climate alignment typifies our TargetNetZero investment grade (TNZ IG) credit strategies, which recently marked three years since their inception. Here we take a closer look at their origin, evolution and the outlook for fixed-income investment in alignment with the Paris Agreement.
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Twin convictions
We see it as our fiduciary duty to help clients both manage the risks and capture the investment opportunities arising from the coming structural and secular transformation of the global economy. We also strongly believe that a truly viable approach to investing in net-zero transition must include select companies in ‘hard-to-abate’ sectors, as these industries will be vital to future economic growth and can make impactful emission reductions. Not only are decarbonising companies in these areas helping accelerate the shift to net zero, they are reducing their exposure to transitional, physical and liability risks and can adapt their business models to a 1.5°C world.
Launched in late April 2021, the same year as the European Central Bank launched its climate action plan, our TNZ IG strategies employ a high-conviction, low-turnover approach to investing in investment-grade (IG) credit with the ability to build opportunistic high-yield (HY) exposures of up to 20%. To achieve their performance and climate objectives, the strategies favour labelled green, sustainable or social bonds subject to the availability of suitable opportunities and without any target allocation.
As these strategies promote environmental or social characteristics, we classify them as Article 8 products under the European Commission’s Sustainable Finance Disclosure Regulation (SFDR).
Zeroing in
The need to transition to a global economy with net-zero greenhouse gas emissions is a defining challenge of our time, creating investment risks and opportunities. Commitments to address climate change span the world, with about 145 countries having committed to net-zero targets – including the major economies of the US, China, the EU and Japan.
Our global and European TNZ IG strategies are aligned with the Paris Agreement. Their key climate objectives are:
- Targeting an Implied Temperature Rise (ITR) of 2°C or lower
- A commitment to making at least 10% of portfolio investments sustainable
- Ensuring exposure to harmful companies is at least 30% below the benchmark
To achieve these aims, we use various proprietary tools developed by our in-house sustainability team and leverage its market-leading research, covering areas such as:
- All-scopes emission assessments, including relevant indirect Scope 3 emissions
- Forward-looking estimates of emissions and ITR
- Ongoing monitoring and reassessment of decarbonisation progress
- Climate-focused engagement and stewardship
Temperature alignment: our proprietary approach
In developing the strategies, we assessed many of the existing metrics being used across the investment industry to build low-carbon portfolios. These metrics aimed to gauge the differential exposure of industries, companies and securities to climate risks and opportunities and the related financial risks. In our view, they were insufficient for the purposes of long-term investment in the net-zero transition. Rather than using backward-looking carbon footprints as our guide, we sought a forward-looking approach.
Adopting the ITR concept, we developed our own science-based methodology to plot the decarbonisation trajectories of industries and companies. This allows us to assess issuers’ alignment with a net-zero future through scenario-based, judgemental analysis. Our ITR metric, which has been referenced by respected organisations including the Portfolio Alignment Team of the Task Force on Climate-Related Financial Disclosures, allows us to summarise the highly complex climate challenge for companies and portfolios in a single figure.
Based on forecasted decarbonisation pathways on an industry-region basis, our ITR metric provides an assessment of the environmental footprints and transition pathways typical of each sector under a 2°C climate scenario. This allows us to identify and favour businesses in hard-to-abate industries – such as agriculture, cement, steel, chemicals, energy, materials, construction and transport – that might have high carbon emissions today but are implementing credible decarbonisation strategies going forward.
Because companies with low ITR scores have the potential to make a disproportionate contribution to ‘cooling down’ the economy, we call them ‘ice cubes’. At the same time, we seek to identify and avoid ‘burning logs’ ¬– high-ITR businesses likely to stay on elevated emission trajectories – which risk becoming stranded assets or no longer being able to operate successfully in a net-zero regulated world.
FIG 1. The current alignment of TargetNetZero strategies to a range of temperature scenarios
Source: LOIM at March 2024. For illustrative purposes only. Metric subject to change.
Hybrids appeal
Our ITR metric enables us to identify issuers that are implementing a credible decarbonisation strategy aligned with the Paris Agreement, and which are likely to be relatively less exposed to transition risks than competitors in the same sector. We would expect these firms to adapt more successfully than peers as the world moves to a lower carbon economy, providing our analysts with additional confidence in their assessment of the long-term viability of the issuer’s business model.
Where we have strong conviction and confidence in an issuer’s long-term prospects, we will generally invest further down the capital structure to benefit from the potential for additional returns. This has resulted in a strategic overweight to subordinated debt – including corporate hybrids, Tier 2 and AT1 securities – from financial issuers.
From a ratings standpoint, corporate hybrids are generally rated two notches below the issuer’s rating, as the bonds are structurally subordinated and there is potential for coupons to be deferred. In the event of default, the recovery would be minimal, but since these bonds are from IG issuers, we anticipate default risk to be close to zero.
We have considerable experience in investing in subordinated securities, with the LOIM Fixed Income team investing in this segment since its inception over two decades ago. We therefore have a strong preference for this type of subordinated debt within our TNZ strategy: it offers potentially attractive financial characteristics while helping to finance – and align investors’ portfolios to – a net-zero future.
Engaging on net zero
We place stewardship at the heart of our sustainable investment approach, integrating engagement throughout the investment lifecycle through a stewardship team working across asset classes. Engaging and acting as a constructive stakeholder to businesses helps us confirm – and reconfirm – that the companies we invest in are aligned with the sustainability transition and are best positioned to benefit from it.
We first seek to understand where companies stand in their sustainability journey, then constructively suggest the changes we believe are necessary to ensure success. Businesses that demonstrate firm intentions towards decarbonisation may have the potential to become categorised as ice cubes once these intentions become actions. Conversely, companies that demonstrate an unwillingness to engage or to adapt their strategies are at risk of becoming burning logs.
Pragmatic progress
Developing a proprietary ITR metric as an integral part of our forward-looking approach to climate investing was an important step in our sustainable-investment journey.
Like all new disciplines, sustainable investing has gone through a process of evolution. As committed proponents, we are committed to playing our part in ensuring the discipline builds on solid principles and evolves to reach its full potential. We believe that both rigour and transparency are vital to this endeavour, and therefore welcome regulatory improvements and support greater standardisation, along with thoughtful, critical debate about the challenges of investing sustainably amid efforts to steer the real economy to net-zero model.
We constantly seek to improve our methodology. In particular, we are currently working to address the following challenges:
- Achieving standardised reporting of data
- Addressing how auditors audit sustainability claims
- Measuring the ITR of financial companies and their portfolios
- Incorporating companies that may have a higher ITR but whose products are critical to reducing global warming
A tough 2022, but the (sustainable) bond is back
Our high-conviction approach means that we are prepared to take on more risk than the benchmark, in a calculated way, and may allocate up to 20% in HY credit in efforts to achieve our performance objectives.
In 2022, high levels of market volatility were detrimental to portfolio returns and have weighed on the performance of the strategies since their inception. In the three years to 30 April 2024, TNZ Europe IG generated an annualised -2.8% relative to the -2.5% return of the benchmark, and TNZ Global IG returned an annualised -4.5% versus the benchmark’s -4% in net EUR and USD terms respectively1.
However, we held our long-term convictions throughout the rising-rate environment and negative sentiment of 2022. This has benefited the portfolios. In the past year, these positions – especially those in the debt of real-estate companies and our exposure to subordinated debt – enabled TNZ Europe IG to deliver 7.2% against the 5.1% of its benchmark, and TNZ Global IG to return 2.7% compared to the benchmark’s 1.5% in net EUR and USD terms respectively1.
FIG 2. One-year performance of the TargetNetZero European and Global IG strategies
Source: LOIM at 09 May 2024. Performance shown is for the TargetNetZero IG Global NA (USD) and TargetNetZero IG Europe NA (EUR) strategies against the benchmarks of the Bloomberg Barclays Global Aggregate Corporates and Bloomberg Euro-Aggregate Corporates TR Index respectively, from 30 April 2023 to 30 April 2024. Past performance is not a guarantee of future results.
On target
Inflation is slowly easing and central banks aim to start lowering interest rates in the second half of 2024. In our view, this reduces default risk and creates a favourable environment for long-term investment in fixed income over cash in general, and subordinated debt in particular. At the same time, the energy transition is progressing, with global solar and wind installations for 2023 still having exceeded our expectations in a torrid year for the sector.
This environment, combined with our active, integrated credit and emissions analysis, increases our conviction in the ability of the TNZ IG strategies to meet clients’ financial and climate objectives.
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