Regulations and the visible effects of climate change are driving investors to seek sustainability solutions. Equity has been leading the charge on this, but the asset class that dominates the portfolios of many schemes is fixed income, so have trustees started to embed sustainability into their bond portfolios? 

 

New regulations on climate risk have only just come into force for large schemes, but pressure on pension funds continues to grow ahead of COP26, the UN’s climate conference in Glasgow next month, with some politicians and campaigners suggesting that net zero should be made mandatory. 

 

 

Pension schemes have dedicated many hours to sustainability and in particular climate recently. As part of this, they are increasingly thinking about how to integrate sustainability into their fixed income portfolios, says trustee director at LawDeb Pension Trustees, Keith Scott. “It's coming up more and more now; it comes up as much in credit mandates as in equity mandates,” Scott says. 

 

The focus on sustainable fixed income is driven on one hand by the new rules requiring disclosure in line with the Task Force on Climate-related Financial Disclosures – as pension funds will have to report on their climate risk exposure, it is important they appoint a credit manager that can do so, he finds. 

 

The fact that many DB schemes have already derisked considerably into bonds is the other driver behind the rise in sustainable fixed income. Even those looking for buyout in the next five or 10 years will want to consider sustainability, he says, because pricing on some securities could begin to change as a result of climate change in particular – and the hope is that the more sustainable option would be less risky and volatile. 

 

Combined, these two drivers mean that there has been a shift in trustees’ views, Scott believes: “It’s amazing how it’s changed over the last few years, it’s such an area of focus now. When we have discussions with any manager on bonds, a big part is ESG. That would never have been the case four or five years ago.”  

  

 

   

    

At the same time as sustainability has moved up the agenda, DB schemes have started to focus on cash flow more. A core part of cash flow management is often a buy and maintain bond portfolio, and this long-term focus aligns well with sustainability, he says. 

 

 

Scott sees UK government bonds – which many DB schemes hold large chunks of, particularly if they aim for buyout – as more difficult in terms of sustainability. “There's a bit of debate going on in terms of what do we do with gilts in terms of TCFD, how do we measure the carbon footprint of the government - that’s to be decided, there’s no industry agreement on that,” he says. Scott also doubts that pension funds can influence government policy. 

 

Pension funds normally hold ‘vanilla’ gilts or index-linked gilts, but the UK government issued its first green gilt in September, raising £10bn in a heavily oversubscribed issuance, with another tranche due to come to market later in the year. Should pension funds try and focus on these instead?  

 

In Scott’s view, green gilts are perhaps even more problematic for pension funds, as they come at a ‘greenium’, offering a lower yield compared with their non-green counterparts: “Normally you’d say, ‘I can live with that because I expect them to be less volatile, have a better risk-adjusted return’, but green gilts have exactly the same risk as general gilts. As a pension fund you are just buying an investment that gives you less return for the same risk.” 

 

 

Labels generally are problematic, he finds, because there can be “a temptation for issuers to put those labels on the bonds because they get debt for a better price”.

For Scott, it is more important that a manager has ESG embedded in its process alongside other investment considerations; trustees may need to spend some time looking at how this influences a manager’s decisions, and how the manager engages with issuers, to understand their ESG approach.

 

Drilling down into a manager’s processes is key, agrees Pete Smith, head of sustainable fixed income at Barnett Waddingham. “We want them to understand the business behind the issuer, what they are financing,” rather than simply basing it on a label, where greenwashing can be more of an issue, he says. 

 

“The easiest way to spot greenwashing is to ask a manager what they haven’t done,” he advises - where managers have to provide examples of deals they did not enter into because of sustainability concerns, even if all the other criteria were attractive. “If they forego what is a financially attractive opportunity, it is a good indicator of commitment,” he believes. 

Amid growing investor awareness and accompanying pressure, there is nonetheless a recognition that the area is a "developing science", and Smith expects data and reporting will improve in time. “One of the large problems, particularly in the fixed income space, is low coverage of useful data. That is why a manager needs to be able to look beyond headline data,” he says. 

 

 

The push for greater sustainability in investments is happening against the backdrop of the still relatively recent global financial crisis and the resulting view that finance should serve society. More specifically, it is driven by governments and other authorities looking to finance the green transition while acting as a catalyst for the private sector, says Scott Freedman, portfolio manager at Newton Investment Management. The Covid-19 crisis has catapulted such programmes ahead of where they might otherwise be. 

 

Amid this acceleration of programmes, there is however currently still a lack of agreed standards. Without this, establishing if a bond has the right sustainability credentials is a process that requires case by case analysis. 

ESG rating agencies can play a role to provide a consensus score or inform about controversies – or opportunities – says Freedman, but they tend to be backward looking. “At the end of the day we have our own taxonomy of assessing material risks", both for corporate and sovereign issuers, he says. 

The research required by managers will only intensify as disclosure expectations increase. “We have to justify each name from a credit risk and sustainability angle,” he adds, as well as demonstrating ongoing monitoring and engagement. 

 

Mainstream capital, more than green capital, will be key for financing the transition, he believes, and the transition will be complex and require multi-factor solutions. A more detailed roadmap from the government would therefore be helpful, he says – and COP26 would provide an opportunity to announce it. 

 

 

The lack of a clearer direction from government has been noticed by others in the industry. One of the problems might be that the UN’s Sustainable Development Goals, which could serve as an overarching framework, were never really set up with a financial application in mind, says Paul Whelan, a partner at consultancy Aon. 

 

This has resulted in “wildly different approaches from managers in terms of the underlying issues they invest in”, he says, and a “huge acronym problem in the ESG world”. 

 

Whelan finds that pension trustees can struggle to understand what they need to do. “When they think they have a handle on the approach, they see three products on selection day that on paper sound similar but have very different approaches to underlying issues,” he says. This lack of consistency and proliferation of jargon leads to decision paralysis by trustees, he argues. 

 

 

The delay in trustee action could mean they are losing out on potential returns. Although sustainable fixed income is still in the relatively early stages, Whelan says that “gone are the days when we thought upping your sustainability integration meant you had to forego your return, we think it’s far more balanced now”. 

 

But it’s not just returns that are lost by not investing. Fixed income investors have an opportunity to be active stewards, says Whelan – at least the larger schemes. 

 

“We can vote with our feet and choose not to participate in new issues or work with the issuing entity to ensure there are some sustainability considerations,” he says, asking for KPIs and sustainability performance targets to be in place. “There is an awful lot that fixed income investors can do,” both on a corporate and a government level, he maintains, as issuers are reliant on external financing. “We are beginning to see more pressure on the laggards to continue to refinance on terms like they used to be able to”, he observes. 

 

To achieve sustainability in fixed income, managers can’t get around engagement, agrees Freedman – Newton has engaged with supermarket company Iceland and Volkswagen among others. However, engagement is not always seeking immediate success. Often, it is necessary just to improve corporate disclosure, so as to avoid excluding companies - or entire sectors - simply because they have failed to disclose, says Freedman: “There is a long way to go on this. It’s about educating companies."