Alphorum: knowledge building in sustainable fixed income

Welcome to the sustainability commentary for the Q4 2021 issue of Alphorum, our quarterly analysis of themes and dynamics in global fixed income.

In this insight, we take stock of the progress made in developing a thriving sustainable fixed-income market amid a record year of issuance and recent criticisms of greenwashing. Using the net-zero transition as a case in point, we discuss how sustainability analysis is becoming increasingly targeted as investors’ knowledge continues to build.

This commentary follows earlier Alphorum insights from the current issue. In our lead commentary, we examine the interplay of current financial, macro and sustainability risks and opportunities in markets, and when assessing developed market and inflation-linked bonds, we track the policy-tightening narratives unfolding and pinpoint where benchmark interest rates are actually rising.

For now, let’s focus on sustainable fixed income.

In the spotlight

There can be no denying that the concept of sustainability in investing has come in for criticism in recent months. Given his insider status, the publication in August of former BlackRock CIO of Sustainable Investing Tariq Fancy’s critique, The Secret Diary of a ‘Sustainable Investor,’has perhaps garnered the most attention.

Greater scrutiny is welcomed by anyone who believes in the value of truly sustainable investing. Some of the criticism from Fancy and others is to some extent justified – such as that of ‘greenwashing’ – and indeed reflects conversations we have had over time as our approach to sustainable investing has evolved. However, we believe that any criticism of sustainable investing must be carefully gauged to save the baby from being thrown out with the bathwater.

We make no apologies for having built our investment approach around the transition to a sustainable economy, and welcome debate and discussion. We want our approach, and what differentiates it from ESG investing, to be properly understood.

Sustainability versus greenwashing

The most common critique of sustainable investing is that it is essentially greenwashing – financial engineering which has no positive impact in the real world. This argument has some validity in relation to the considerable number of passive, ESG-screened funds which have sprouted like mushrooms amid the capital inflows into sustainable investing.

Indeed, there are those who want to ‘be seen to be green’ while doing the bare minimum. However, there are also sustainable investors who, like us, have conviction in a truly future-focused approach. This is less about investing in the low-hanging fruit of existing leaders in inherently low-carbon sectors, and much more about firms who are leveraging the value-creation opportunities sustainability has to offer. Amid the current focus on net zero, that includes genuine transition stories in sectors where carbon emissions are hard to abate, like steelmaking and energy.

The importance of knowledge building

The sustainable investment universe is growing rapidly, as is the information available about it, yet sustainability as a mainstream investment approach is arguably still in a nascent stage. Rather than deliberate greenwashing, often the problem is a lack of understanding of sustainability risks among investment practitioners, which is exacerbated by the difficulty of accessing information to ensure an investment is truly sustainable.

In this environment, everyone is learning – companies and investors alike. The complex, interlinked nature of sustainability issues, the existence of multiple definitions and standards, and the lack of complete data sets make quantifying the risks and opportunities challenging. That does not invalidate the concept of sustainable investing, it simply means we all need to keep building the knowledge required to get better at it.

One way in which we aim to advance the field of sustainable investment in this respect is through Implied Temperature Rise (ITR) metrics. Unlike carbon intensity, which is a widely used metric focused on past emissions, temperature alignment is a forward-looking metric that incorporates expected future emissions to project temperature trajectories for companies, which helps us understand whether they are adapting to a net-zero future.

We believe this provides a much clearer long-term view of transition risk in a portfolio. Such forward-looking metrics are likely to become increasingly mainstream, particularly following the release of a major report on the topic by the Portfolio Alignment Team of the Taskforce on Climate-related Financial Disclosures (TCFD). This report not only encourages the use of such metrics, but also provides specific guidance on best practices for their construction.

Not all green bonds are equal

The amount of sustainable bond issuance is growing rapidly to meet strong demand (see figure 1). Linking bonds to sustainability – either by committing the proceeds to actions aligned with environmental preservation or tying coupon payments to performance on appropriate metrics – has become incredibly popular. To a large extent, if a company can issue a green or sustainability bond, it will.

FIG. 1: Sustainability-bond issuance has surged to an all-time high

Source: Bloomberg New Energy Finance, LOIM as at September 2021. For illustrative purposes only.

Of course, while increased issuance is to be welcomed, it is not in itself a guarantee of a high quality, truly sustainable investment. There is still a need to be selective, not only by looking at the use of proceeds or the conditions attached, but also by considering the real-world impact. Are the targets suitably ambitious or do they simply reward a company for practices that remain largely business as usual? Are the consequences of defaulting on targets sufficiently punitive? Beyond that, there is the overriding need to undertake due diligence on the company as a whole to ensure it has strong credit fundamentals and is able to repay the bond, as well as a clear pathway to achieving its sustainability targets.

The importance of an active approach

This is where an active investment strategy clearly distinguishes itself from a passive approach which tracks an ESG benchmark. Having a proper understanding of both the internal culture of a company and the context in which it operates is vital to turn a two-dimensional, backward-looking exercise into one that understands how sustainability factors are aligned with the future success of a business.

Targets are one thing, but does an issuer have the means, the motivation and above all the will to achieve them? What are the barriers and drivers coming from its customer base, its shareholders, its employees, its competitive environment, the regulation in its sector and wider society?

Returning to the topic of net zero, we believe that combining an assessment of implied temperature rise with fundamental credit analysis, which includes the issuer’s governance practices, allows us to develop a much clearer picture of whether a firm is likely to achieve both its financial and environmental targets.

The tipping point has been passed

Five years ago, the concept of sustainability existed on the peripheries of the investment industry. Since then, interest has grown so quickly that we have already passed the tipping point at which sustainable investing becomes a self-fulfilling prophecy. As inflows increase, more eyes will be scrutinising the sustainability claims and strategies of companies. Policymakers, regulators and even central banks are among those placing increasing importance on sustainability. This will inevitably generate more data and stronger oversight, which will foster a more rigorous approach in the future.

Fixed-income maturities are inherently aligned with a sustainable approach

The scale of the energy transition and long timescales for climate targets mean sustainability is often seen as a long-term play. This aligns well with the investment horizon of many fixed-income investors. It is important to keep in mind that the companies providing the best returns now will not necessarily prevail and be successful in the long run; in fact, they may be creating longer term risk for short-term gain. Neither are improvements in sustainability linear and smooth, especially when looking at an individual company. Significant levels of resource and capex can be involved, so it can take time for measures to have an impact on a company’s bottom line.

That is not to say that sustainability cannot be important in the short term. As fixed-income investors, our primary focus is always on risk. Attitudes can change quickly, closely followed by policy, regulation and investment flows (not necessarily always in that order). Companies that proactively address sustainability in a meaningful way tend to reduce their exposure to risk, making them more attractive long-term investments.

Leading, not following

In the conclusion to The Secret Diary of a ‘Sustainable Investor, Tariq Fancy foregrounds the importance of government in setting the rules within which a sustainable global economy can be built. There is no doubt that regulation has an important role to play – the work done by the TCFD on forward-looking metrics is a good example. Technology and innovation will also be crucial. However, we cannot wait for governments. Investors need to act now to help create the market and drive change; and to provide structure by generating new metrics to capture the changing risk landscape we are facing. This process of information discovery is something we are proud to be part of and see as a key source of alpha generation for our clients’ portfolios. 

To read the full Q4 2021 issue of Alphorum, please use the download button provided.

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