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Responsible Resolutions: This is the latest article in a series from sustainable finance practitioners about their hopes for the New Year.
It is always fraught making New Year’s resolutions on other people’s behalf (try telling your partner “I think your resolution should be to go more to the gym next year”) but here is my proposition for European financial regulators.
We see a deep demand from retail and individual investors for impact investment products. However, some regulatory hurdles introduced in a benevolent way to protect retail investors, unfortunately also hinder what could potentially be the most impactful investment products. I would ask for a resolution on regulators’ behalf to allow physical bond shorts to enter UCITS format strategies, as a response to investor demand for climate-related impact investments, but also from the purely egotistical perspective of hastening the capital re-allocation needed to combat climate change.
In an earlier RI comment, I made the point that bonds might be one of the most impactful ways for investors to influence corporates and other climate relevant financial entities. In particular, we illustrate how bond short positions could potentially have very large impact on climate policies and fossil investment projects. But such positions are currently explicitly disallowed from the €10trn UCITS fund market – the primary domain of retail and smaller investors in Europe.
I would ask for a resolution on regulators’ behalf to allow physical bond shorts to enter UCITS format strategies.
Why is this? As a background, the main and commendable argument for prohibiting physical shorts is to protect UCITS investors from unlimited risks. A stock can go to infinity on the upside, but only to zero on the downside, creating an asymmetric return profile for the investor of unlimited upside and capped downside. For the short seller of the stock, the reverse is true: they have unlimited downside and a capped upside. Ask the short sellers of Tesla equity, they have suffered some fairly severe losses over the past six months.
But the asymmetric risk argument is invalid for bonds: bond prices, and thus returns, are more-or-less capped (*). The priciest bond that I ever came across, I sold at a price of $175, which hardly is an unlimited upside from the nominal value of $100. A short seller, when the bond is near par (=$100), has an almost symmetrical risk-profile – approximately speaking, the bond can lose 100% or gain 100% in mark-to-market terms.
For large parts of the bond markets, there are also no alternatives (CDS or otherwise) to short entities but to do so in physical short format. Not having access to that option becomes problematic for climate impact strategies. For example, our Diem strategy suggests shorting various bonds in the capital structure of a corporate conglomerate as a consequence of its construction and operation of one of the largest coal mines in history. The mine is the first in a planned development of a coal deposit in Australia, which – if fully developed – would contribute 25Gt CO2 emissions, or equivalent to around 5-10% of the remaining carbon budget for the Paris accord. It is a trade with very clear implications for carbon emissions.
From a trading standpoint, we believe that investors in those bonds are weak holders and could quickly become forced sellers if they started applying coal exclusion criteria for real. This could potentially result in a significant price drop and gains for short sellers. We furthermore believe the short positions are the right trades from a climate impact perspective: short-sellers drive the price of bonds down with the commensurate push up in yield, and can produce a direct and negative cost-of-capital effect for the issuer when refinancing occurs.
The downside risk of such a trade is in line with a traditional long based position. The bonds in our case currently trade slightly north of par (=100) and if we assume a yield of the 10yr bonds of 0%, their price would still just be $141.
We shall not speculate on the upside of the trade in terms of P&L, but clearly, a trade that could contribute to the mothballing of this enormous coal field is attractive from an impact standpoint. Indeed, we would argue that it could potentially be the most important trade of our careers. We are talking gigatonnes of CO2 emissions after all.
We believe that investors in those bonds are weak holders and could quickly become forced sellers if they started applying coal exclusion criteria for real.
You may not think this is a compelling case, analogously to how we think a cannabis-focused strategy is not attractive. But today you can create a UCITS structure on the latter, but not the bond short-based climate case, even if the risk might be significantly higher in a cannabis strategy. This just does not seem sensible.
Bond markets matter. At roughly twice the size of equities market in terms of market capitalisation, they are clearly relevant for issuers. They have a more direct effect on cost of capital compared to equities. They provide funding to many more entities than public equity markets. And currently, they supply large amounts of capital at very low cost to the planet’s most unsustainable financial entities. And exactly those entities are hard to short by any other means than physical shorts.
To summarise, I believe allowing bond physical shorts under UCITS umbrella would lead to a quicker aggregation of capital to flatten out the carbon bubble, as well as meet the demand for impact investments among retail investors, without having detrimental effects on the value of the UCITS format as a safe investment form.
(*) An extreme case could be argued whereby bond trading at heavy discounts (below par) could from a mathematical context give unlimited downside in a short-selling situation. An investor short-selling a bond trading at $1 would be liable for almost unlimited downside if the bond returns to par and the funds capital has been invested on the basis of the market-value of the bond rather than its nominal value. There are very straightforward solutions to this, that likely are already covered under other risk limitation instructions in the UCITS directive.
Ulf Erlandsson used to run credit portfolios, including green bonds, at Swedish pension fund AP4 and is now the head of credit-focused climate strategy Diem Green Credit.