An innovative approach and framework for identifying climate transition risks and managing climate change in fixed income portfolios.
Regulatory, societal and investment pressures are driving greater awareness of climate-related risks. At the same time investors face many challenges, including a backdrop of negative real returns on cash which demand they consider alternative investment solutions.
This article discusses why short-dated corporate bonds which are relatively close to maturity can help investors capture attractive yields with minimal interest-rate sensitivity, low portfolio volatility and good levels of liquidity – all while having a relatively low climate-related risk.
The appeal of short-dated investment grade bonds
The unique characteristics of short-dated bonds offer investors an opportunity to access a lower- volatility segment of the broader investment-grade fixed income market.
Short-dated investment grade bonds can offer attractive and relatively consistent returns against a market backdrop of negative real returns. Chart 1 below highlights that you can enhance your yield by taking modest risk through investing in short dated corporate bonds from good quality companies without taking on additional interest rate (duration) risk.
The appeal of short-dated bonds is based on a range of factors, including:
- A long-term record of generating attractive risk-adjusted returns.
- Capital-preservation qualities – higher resiliency to negative company-specific events than longer- dated bonds.
- Less susceptibility to fluctuating interest rates as returns derive from credit risk rather than duration risk.
- Steady cashflow generation paid-out as an income or reinvested to take advantage of further opportunities.
- Higher liquidity than longer-dated equivalents, due to the high frequency of bonds reaching maturity.
Short-dated investment grade bonds offer attractive yield and spread for low duration
Furthermore, with short-dated bonds there is no material yield sacrifice for a reduction in climate risk which is a benefit that we now explore in more detail.
Assessing climate transition risk
Understanding the potential risks to company cash flows is vital to retain the conservative nature of short-dated bonds. Actively managing ESG risks, including climate related risks, should therefore play an important role in investment decision making.
To assess the materiality of climate change risks for bonds, research typically focuses on the potential impacts of transition and physical risks. This involves assessing a range of carbon emission metrics to help investors consider the carbon footprint of various investments.
When focusing on transition, the next stage in climate risk analysis is to assess a company's ambitions, performance, and management toward net-zero. This goes beyond backward-looking emissions to form a forward-looking view of a company's transition readiness and alignment with the energy transition.
Analysis can be conducted for issuers across a wide range of industry sectors and may consist of an examination of:
- Long-term ambition and associated targets
- Historical emissions trends and disclosure
- Climate / environmental management, governance and strategy
More in-depth analysis should be considered for issuers in sectors deemed to have a stronger ability to influence the achievement of global climate goals. This influence can be direct as a result of their emissions or products, for example oil & gas or utilities; or indirect as a result of their ability to influence the activities of others, for example banks. In these sectors, it is important to understand the idiosyncratic considerations and issues faced by companies and tailor climate analysis accordingly.
Rather than simply exclude high influence sectors, this type of research can help to identify and support those companies that have robust and credible plans to transition towards a low carbon economy. Furthermore, the design of the research framework can be compatible with external climate initiatives such as the Net-Zero Asset Owner Alliance and the Paris Aligned Investment Initiative, while a complementary active engagement can play an important role in encouraging more aggressive climate-related targets and helping to improve the quality of disclosures.