Bonds: An Action Plan for Net Zero
State Street Global Advisors present an action plan for fixed income investors that balances climate concerns, data and value to drastically improve climate profiles of bond portfolios while maintaining financial performance.
Understanding Net Zero
Scientific models that target a temperature rise of less than 1.5°C over and above pre-industrial levels show that we need to achieve net zero emissions by the year 2050. Simply put, net zero means that the total emissions being emitted should be lower than or equal to the total emissions being removed/absorbed. On a net basis, no additional emissions should be released into the Earth’s atmosphere.
Recently, net zero investing has taken centre stage, and a number of related investment frameworks have been put forward by various investor/regulatory initiatives. For example, we have several sustainability-related regulations from the European Union, the Net Zero Asset Owner’s Alliance, Net Zero Asset Manager Initiative and the Paris Aligned Investment Initiative (PAII) by the Institutional Investors Group on Climate Change (IIGCC).
Even without the impetus of net zero and potentially game-changing regulatory initiatives such as the Sustainability in Financial Services Disclosure Regulation (SFDR) — which aims to improve transparency across the financial services ecosystem as to how and where sustainability risks are factored into investment decisions — many companies are proactively taking steps to reduce their carbon footprints and disclose their exposure to climate risks.
Portfolio Impact: Risks and Opportunities
Increasingly, investors are recognising that climate risks are financial risks. Climate change is the highest priority among UN PRI signatories, representing over 3,000 investors and over $100 trillion of assets. For investors, climate change and its impact on asset valuations are therefore becoming important criteria for investment decisions.
Companies face a multitude of climate-related risks, including supply chain disruptions and shortage of raw materials, falling demand for products and services, and carbon taxes and other regulations.
Accordingly, investors are either strongly considering or actively implementing appropriate climate-focused investment strategies.
An Action Plan for Fixed Income
Most relatively sophisticated investors have by now developed their approaches for equity investments, but for fixed income investors the path has not been so clear. Bond investing is very different from equity investing and it’s taken some time for the marketplace to develop the right solutions for the more diverse and opaque bond markets.
At State Street, a key part of our approach to address these issues has been to develop a Sustainable Climate Bond strategy.
To help investors immediately improve their portfolio’s carbon profile and reduce climate risk, while maintaining target returns, we developed a strategy with a four-step process:
1- Start with the Right Universe
We start with any standard investment grade, high yield credit or aggregate benchmark. For each exposure, we first incorporate a set of screens that are aligned with key climate and ESG objectives.
We start with three sets of exclusions based on product involvement and prescriptive regulatory screens:
Exclusionary Screening Criteria
- Climate Related Exclusions using measurement such as Carbon Intensity, Fossil Fuel Reserves and Brown Revenues
- ESG Risks and Reputation Risk Related including UN Global Compact Violators, Controversial Weapons/Armaments Screens and companies involved in Severe ESG Controversies
- Prescriptive Regulatory Screen, based on Swedish Ethical Council criteria.
2- Source the Best Data
All investment strategies rely on relevant and high-quality data and climate strategies are no different. At State Street, we employ an open architecture to source the best-available data. Sourcing the right climate data is not easy but it is critical if you are to achieve the right results.
We researched many different data providers and aligned on different providers for carbon emission intensity, fossil fuel reserves and brown revenues; green bond & climate-aligned issuers; adaptation scores; product and controversy involvement as well as our own R-Factor™ ESG rating, based on the SASB ESG risk materiality framework.
With the right data, the right decisions can be made.
3- Design for Optimal Outcomes and Balance for Risk-Adjusted Return
We utilise a mitigation and adaptation framework to rebalance the portfolio towards companies that will achieve our stated objectives. We then balance the portfolio to target the highest expected risk-adjusted return, given the desired constraints.
Our base strategy models the portfolio based on the following specifications:
- 70% or greater reduction in GHG emissions
- 95% or greater reduction in companies involved in brown sectors or that have fossil fuel reserves
- 100% exclusion of companies that violate ethical principles relating to corruption, human rights, labour standards, serious controversies, controversial weapons and tobacco
- 1.5 Adaptation Score, below which a company will be ineligible for inclusion in a Paris-aligned portfolio
- 2.5x or greater increase in green bonds (recognised as green according to the green bond standards and EU taxonomy defined by the Climate Bonds Initiative)
4- Maximize Value with Indexed Offer
Finally, the portfolio is implemented using an indexed approach to deliver a consistent, cost-efficient and diversified investment exposure. This approach is built around stratified sampling, which State Street Global Advisors pioneered. With around ten thousand issues in the broad corporate bond market, buying every bond is not a cost-effective approach for replication.
Skilled sampling can replicate the broad risk profile of the relevant corporate index efficiently and effectively, with a fewer but still highly diversified set of holdings.
In addition, we employ sophisticated indexing techniques focussed on minimising costs and tightly controlling systematic risks, while also adding value.
The Right Approach Yields Results
Bond investors have historically not been as well-served as equity investors in the climate space. But net zero and other market shifts make it imperative that bond investors consider well-designed options.
The right strategy will balance climate concerns, data and value to drastically improve climate profiles of the portfolio while maintaining financial performance.
Marketing Communication. For Professional Clients Use Only. The information provided does not constitute investment advice under the Markets in Financial Instruments Directive (2014/65/EU) and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor's or potential investor's particular investment objectives, strategies, tax status, risk appetite or investment horizon.
© 2021 State Street Corporation. All Rights Reserved.
Exp. Date: 28.02.2022