Rhys Petheram, Head of Environmental Solutions, discusses the primary considerations in applying an ESG thematic approach to fixed income. He also examines the new innovative tools that are available to fixed income investors, as well as portfolio construction considerations and his approach to risk management.
What is thematic investing?
Thematic investing is an approach whereby investors are focused on a particular structural theme or investment opportunity. This investment theme could run across sectors or style biases, and there is a wide-ranging number of funds available to investors, spanning those with a focus on demographics, fintech and environmental themes.
In terms of equity funds, the growth in thematics has been considerable over the past few years, with fintech and climate change as the main focuses. Generally, thematic funds tend to focus on an accelerating growth theme, or by identifying an S-curve. These curves look at the penetration rates of adoption of a particular technology or product – they tend to show a slow rate to begin with, before hitting an accelerated phase.
The benefits to equity investors are reasonably obvious: as long as you’re not paying upfront for earnings growth, it could translate into capital gains. Furthermore, as companies mature through the S-curve, there’s scope for equity multiples to improve as businesses become more robust and their competitive positions become more sustainable.
Thematic investing for fixed income
So, what does it mean for fixed income investors? Clearly, earnings growth and more sustainable businesses are attractive features for fixed income investors, too. But it’s more nuanced: when our team looks at S-curves, we think about execution risk, in terms of deploying capital and with uncertainty about whether returns will come through; and we also think about how the accelerated growth phase is going to benefit various business stakeholders, namely bondholders. For every S-curve, there’s also a “loser curve” to consider – some sectors and businesses will lose out due to the acceleration in these trends. Avoiding these losers is another important component of our process.
Delivering on sustainability objectives
A particular area of focus for investors – and for regulators – has been the role that portfolios play in delivering on sustainability objectives, particularly around climate change.
This is where fixed income really comes to the fore – we’re not just talking about the behaviour of companies, but also who is going to enable that journey for companies. In terms of the pathway to net zero, it’s estimated we need approximately $5tn in clean energy investment to meet climate objectives by 2030. Fixed income markets play an increasingly important role in the ongoing provision of fresh capital into markets.
So, for fixed income, thematic ESG investing isn’t really about big beta bets on earnings growth – it’s about the benefits that come from active portfolio management, and meeting expectations from asset owners and regulators in terms of understanding the role played in big sustainability challenges.
Financial innovation – green bonds laying a foundation
What tools are available to fixed income investors? A clear change in the market over the past decade has been the introduction of the green bond market. Green bonds are those that are issued by any entity, where the proceeds are specifically earmarked towards projects that deliver environmental solutions. The first green bonds were issued in 2007, by the EIB, labelled ‘climate-awareness’ bonds, but the market stayed very small for years, and only really got going when markets developed industry guidelines and standards, and associated certifications and verification processes, between 2011 and 2014. This gave investors and issuers the confidence to start issuing on a greater scale.
One key feature of these “labelled” green bonds is that they’re typically not asset-backed deals – instead, it’s an earmarking process. Therefore, they’re not actually driving change in their own right, but they have become an important part of the journey for companies trying to implement sustainability strategies.
The concept of green bonds is spreading into other areas, too. There’s been a significant pickup in social bonds, for example e.g. those focused on hospitals, schools, covid-recovery bonds, etc. There are also other areas like sustainability bonds, which are a combination of social and environmental; and transition bonds, which focus on those companies that are high emitters becoming lower emitters, but transition bonds have struggled to gain traction.
The new sustainability-linked bond market is different as it’s not about individual projects, but it’s instead focused on the sustainability objectives of a company, whereby the financial performance of bonds is linked to those objectives. This market is growing rapidly, though it remains very small, and investors and issuers are still trying to navigate it. Its coupon is typically linked to an issuer achieving a particular environmental or sustainability objective, with a focus on corporate performance, rather than individual projects.
These bonds represent some challenges: are the targets ambitious enough, and is the penalty high enough to influence management? There’s also an uncomfortable feature whereby, as sustainability investors, we benefit if they don’t meet their targets. Given these challenges, we prefer to focus on deals that have the sustainability impact of the company at the heart of its key performance indicators (KPIs). We prefer KPIs that are linked to management remuneration and back-end penalties (which hit at maturity). We want to see a focus on the impact of social loss if these companies miss their target, rather than an impact on the capital value of the instrument.
Finally, there is the “unlabelled” green bond market, with bonds issued by conventional issuers whose underlying economic activity is focused on environmental solutions (water, utilities, renewable energy etc). Investors’ role is to support the capital structure of companies to enable them to address these environmental challenges.
So, it is a versatile market, with a number of ways investors can tap into ESG themes through fixed income investing – be it through labelled green bonds, social bonds, transition bonds, sustainability-linked bonds, or unlabelled green bonds. When investing through these markets, it’s important to be aware of additionality, i.e. whether the activities financed by a green bond would have happened anyway, and whether these bonds are meaningfully contributing towards tackling issues such climate change; weaknesses in the market; and the fact that green bonds are not drivers of change, though they do play a key part of climate strategy.
Green bonds laying a foundation – labelled bond issuance by year
Source: Bloomberg, as of 31.03.2021
Sustainability objectives may be driven by corporate values or missions, or by policy and regulation. But portfolio construction is rudderless without a clearly defined objective, as it defines your universe.
Our Environmental Solutions team has identified two key challenges: climate change, and natural capital depletion. On a standalone basis, they’re the largest challenges of our day, but they’re also intertwined. A warming planet has implications for our land and ecosystems; but at the same time those same natural capital assets represent important components of the global risk mitigation strategy for climate change. Our universe is comprised of companies whose operations deliver solutions to these challenges.
The challenges of climate change & natural capital depletion
How do we approach risk management?
In terms of risk management, first, we must consider active risk: if you take a component or allocation away from your conventional portfolio and allocate it to a thematic one, what is the active/incremental risk involved? The difference in tracking error of a green equity and green bond portfolio versus their respective broader universes is considerable. For fixed income, this allocation process and the active risk involved is more manageable. Risk drivers for green equities tend to be idiosyncratic, but for bonds, they’re more conventional risk factors – interest rate, credit beta risk etc that drive structural risk.
The second risk consideration is in terms of which benchmark to use. The high-growth nature of the market presents considerable instability for the index, which makes it difficult for passive fund allocations. For our strategies, we view more conventional indices as just as appropriate, although this dynamic will improve as the sustainable bond universe matures.
Finally, the last consideration, and in our view, the most important, is whether there is enough breadth to be able to actively manage portfolios. Is there enough access to key risk factors for fixed income in terms of interest rate and spread risk? It’s somewhat mixed – on a global basis, we would say there is, but if you drill down to a sub asset class like US high yield, for example, there is not enough to actively manage these portfolios.
However, we choose to combine unlabelled and labelled bonds for our universe, which provides ample breadth to be able to actively manage these portfolios. We believe this market breadth is key if we are to manage risks effectively.
Portfolio construction in practice
Orange dots denote article 9 funds within Morningstar Peer Group – 5-year performance
Source: Morningstar 30.06.2021. Peer group = Morningstar EAA OE EUR Moderate Allocation – Global.
The value of active minds – Independent thinking
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