Short-term govvies not exempt from transition risk, warns MSCI

Research finds 'maturity matters' when considering transition scenarios, with five-year US treasuries seeing a 'sizeable' 100bps yield shock in some scenarios.

Short-term bonds are not exempt from transition risk, warns investment research firm MSCI in a new paper.

Its analysis showed the possibility of “sizeable” yield shocks to government bonds with shorter maturities under certain transition scenarios.

Bhaveer Shah, vice-president, ESG research at MSCI and author of the paper, said: “It’s not always intuitive and it’s not always that long-term bonds have more climate transition risk than a short-term one.”

If the world meets the most orderly of transition scenarios, then government bonds with shorter maturities could see the largest yield shocks, whereas disorderly scenarios would see shocks for longer maturities. MSCI’s paper warns that investors shouldn’t generalise transition risk “as simply a distant issue relevant only for longer-maturity portfolios”.

MSCI uses the six climate scenarios set out by green central banking group The Network for Greening the Financial System (NGFS). These range from from an orderly transition to net zero, which would keep global warming to 1.5C – called the “Net-Zero 2050” scenario – to “hothouse world” scenarios where only currently implemented policies or Nationally Determined Contributions are considered.

Under the Net-Zero 2050 scenario, China and the US see the biggest yield shocks to their five-year bonds, with possible increases of as much as 100 basis points, with Singapore, Vietnam and Hong Kong also badly affected. The UK could see increases as high as 50bps, while the EU, Germany and France would be less badly affected at around 25bps.

Yield increases are not just driven by the scale of decarbonisation needed, the paper said, but also by “how quickly that change influences macroeconomic variables, such as inflation, within that country”.

This trend is reversed under the more disorderly “divergent net zero” scenario, with 20-year yields in a number of countries, including the US, Turkey and Canada, seeing significant rises, and falls of as much as 125bps for some five-year bonds.

Shah said these shocks could be ascribed to the macroeconomic impacts of the transition.

“You’re seeing on one side of the equation a risk to growth, which sometimes ends up being a positive ‘green boom’ risk or sometimes ends up being more of a negative adjustment when you’re trying to decarbonise”, he said.

“On the other hand, you have this inflationary shock that the economy cannot simply ignore. It will manifest as you try to decarbonise according to these models. So, macroeconomically, what’s happening is that interest rates in the central banks in this model are adjusting to this reality of high inflation versus potentially downside growth rates. It sounds very similar to what’s going on in the world right now.

“It’s not the textbook conventional case that the long term is always where the risk lies… we’re not talking about 3-4bps, we’re talking about a structural risk that is a bit more sticky as countries decarbonise. It’s almost as if this model is trying to tell you that markets need to get used to a new reality, or new equilibrium.”

On an individual country level, the underlying causes of these shocks can be divergent. In Singapore for instance, the rising yields under a Net-Zero 2050 scenario are due to “a positive shock to GDP” from a green boom and high infrastructure spending accompanied by an inflation shock. Vietnam, whose five-year bonds would also see a significant yield shock under the Net-Zero 2050 scenario, would have quite high inflation risk accompanied “[by] a more muted GDP backdrop”, Shah said.

The paper warns that these yield shocks are not just limited to countries with higher emitters. Sweden, a country with lower per capita emissions compared to the US, produced similar results when run through the scenarios. “Yield increases are not solely driven by size of the decarbonisation journey,” the paper explained. “What matters, too, is how quickly that change influences macroeconomic variables, such as inflation, within that country.”

Among the paper’s other findings are that transition risks generally have “modest” impacts on country GDP. While decarbonisation involves major changes to national energy systems and economic sectors, it said, “[the] aggregated impact on the level of national GDP is mostly diluted over the decades”.

The GDP research reinforces analysis by German promotional bank KfW, which forecast in late May that a credible transition would not lead to increased default risk, and that transitions efforts would lead to raised GDP from 2060 onwards, particularly in emerging markets.