How are investors tracking climate risks in fixed income?

Rising interest rates have sparked a resurgence in institutional demand for bonds. But alongside inflation and credit risk, fixed income investors are now facing a new challenge, the impact of rising temperatures. Fixed income investors now face a simultaneous challenge of reducing the carbon footprint of their portfolio whilst also managing climate risks. 

Recent findings from the Institute for Energy Economics and Financial Analysis have made the case that credit ratings are underplaying climate-related risks, something which should be of “grave concern” to bond market participants who value stability.

Few investors value stability more than those in the institutional space, planning returns for those retiring decades from now, and typically dedicating large amounts of resources to the fixed income sector. Consequently, assessing and minimising climate risk in bond portfolios is becoming of paramount importance.

Indeed, more than a decade of quantitative easing has led to global bond markets ballooning to $133 trillion in assets as of 2022, according to the Bank for International Settlements, while global equity assets stand at $120 trillion on assets. Such is the size of the market, bonds may be the most important asset class for decarbonising an overall portfolio, particularly for institutional investors such as insurers or mature defined benefit schemes, who may have a majority of their assets invested in fixed income. 

Picking the right bond

When selecting bonds, investors are now considering both the carbon footprint of the bond itself, as well as the climate risk that the issuer might be exposed to. 

“It is essential to consider the environmental impacts of bonds before investing, both for risk-mitigation purposes and to deliver positive outcomes”, says Bruno Bamberger, solutions strategist at AXA Investment Managers. “Most of the bonds AXA invests in we intend to hold for years and the world is likely to see profound environmental changes over these time periods; ignoring environmental considerations would not be giving the duty of care to our clients that they deserve.”

For James Monk, investment director for Fidelity International's FutureWise strategy, which is the default fund for the managers master trust, a key to sustainability comes from examining the firm behind the issuance: “A lot of the focus is on the issuer, and the types of investments that they make, with very few bonds attached to a specific project. As a result, the equity risk management or sustainability outlook of the of the issuer is really important for identifying that sustainable value.”

Data challenge

But assessing the emissions associated with a fixed income portfolio is far from straightforward, and lack of consistency on data remains a challenge. 

One method to measure emissions in a portfolio is through the weighted average carbon intensity (WACI), with such data collected by firms such as MSCI. A limitation of WACI is that certain asset classes are excluded from calculations, including government bonds, which means that the coverage of fixed income holdings can be limited.

Bamberger says: “Having accurate and broad data coverage is vital for decarbonising a bond portfolio, but it takes time, expertise and significant resource to digest and apply carbon emissions data from the industry to client portfolios.

“While fixed income is often more complex than equities due to different sub-issuers from the same parent company, the carbon emission data from the same issuer can equally be used for debt and equity investors.”

There may soon also be progress in this area on a regulation front. First reported in July this year, major banks including Morgan Stanley, Barclays and Bank of America are developing global standards for accounting carbon emissions in bond sale underwriting, overseen by the Partnership for Carbon Accounting Financials.

Green issuances

One way to improve the carbon footprint of a portfolio is to focus on those fixed income instruments with a defined environmental goal; green bonds. There is clearly great enthusiasm for such bonds in the marketplace, with those with credible frameworks and free from greenwashing allegations likely to be well oversubscribed.

In June, the German state of Baden-Württemberg issued its third edition of green bond, with proceeds used to refinance ecologically sustainable projects and plans in the region.

Speaking on the Sustainable Finance Podcast, Arnim Emrich, head of treasury for Land Baden-Württemberg, said: “The demand was good in all three issuances, but the most recent has really surpassed any expectations, eight times oversubscribed.

“Historically we had a lot of German investors, maybe some from Austria, in our bond issuances. This green bond issue really covered international investors including the US and Middle East, and we had a lot of EU investors from Scandinavia to the Netherlands.”

However, while there may be great international investor demand for green bonds, the market is not yet large enough to accomodate it. In 2022, the global bond market was $133 trillion, and while having grown exponentially since its inception in 2007, the green bond market was $2 trillion at the end of last year, or 1.5% of the overall.

This disparity means that regardless of intention, it is not feasible for asset owners to have majority green bonds within a fixed income portfolio.

As to why green bonds are showing less take-up on the issuer side, Monk explains: “It's possible not as many issuers want to sign up for the green bond structure because it very clearly incentivises a change of behaviour, and it signs them up to a very specific set of rules and statistics that perhaps might not necessarily be useful in the future.”

One solution suggested by Monk is that, even as at a time when the UK’s Financial Conduct Authority is introducing a dedicated labelling scheme via the Sustainability Disclosure Requirements (SDR), is to exercise greater caution in outrightly defining a green bond when identifying wider key climate risks within the issuance may be the priority.

“It’s not always fair to say whether a bond is ‘ESG’ or not, there's typically going to be a spectrum there. There is a need to engage with and just try and better provide transparency on the ESG credentials of issues”, he says.