Justine Vroman and Tom Chinery discuss the opportunities in investment-grade credit to drive climate action.
Read this article to understand:
- The outlook for investment-grade credit in 2023
- How to achieve climate impact through investing in solutions providers and transition leaders
- Why Paris-aligned benchmarking may not be the most effective measure of change
The outlook for investment-grade (IG) credit is radically different to a year ago. With inflationary pressures remaining elevated, central banks have aggressively hiked rates to counter them. Change is not limited to financial markets; it can also be seen in the growth outlook and energy policy environment. Meanwhile, major climate challenges remain.
The outlook for investment-grade credit is radically different to a year ago
We sat down with the co-managers of the Aviva Investors Climate Transition Global Credit strategy, Justine Vroman (JV) and Tom Chinery (TC), to discuss where they see opportunities in IG credit and how they are positioning for change.
2022 was hard for many asset classes. Are you more optimistic about 2023?
TC: If you think about the coupon and carry (return) from holding IG credit, 2023 looks very different to 2022. Risk-adjusted returns look much better now, which should give more room to absorb volatility through the cycle. On that basis, we believe IG credit looks appealing compared to other asset classes; it’s able to offer investors something it has not been able to for some time – yield.
JV: Global IG credit is offering average yields close to five per cent, the highest level since 2009, with the exception of Q4 last year.
Although central banks are yet to respond to the latest macroeconomic data releases, the environment is quite supportive, with lower interest rate volatility compared to last year. The economy is digesting one of the fastest, most intense rate-hiking cycles on record and that is going to have consequences, especially in the lower-quality end of the credit spectrum.
In IG, we expect pressure on company earnings and margins, but overall fundamentals are relatively healthy. Prudent balance sheet management should allow companies to weather the storm in a higher rates environment. Nevertheless, spreads have tightened in the past three months, which makes us more cautious in our positioning.
Our climate transition credit strategy was resilient last year versus global IG and global IG ESG peers. The conditions could have proved a perfect storm for the climate thematic because energy outperformed sectors like consumer cyclicals and corporate hybrids that we use to offset our structural energy underweight.
We adjusted our positioning, and that largely limited downside risk
We recognised the issues early on and realised historical correlations were not going to hold. We adjusted our positioning, and that largely limited downside risk. It is a good illustration of how portfolio construction and active risk management can deliver better outcomes.
The energy crisis and the policy initiatives that followed, like the US Inflation Reduction Act (IRA), offer a reminder that climate risk is a key investment consideration. That should support momentum for the strategy.
What is it about climate risk that is hard to assess?
TC: Bond funds have been slow to assess climate risk because of data challenges. It takes a huge amount of effort to carry out the qualitative and quantitative work needed.
In the past, bondholders had a slightly easy opt-out, where they have been able to say: “We have just bought a green bond, where the use of proceeds has low emissions.” We think the right way to look at this is through the underlying company, not the use of proceeds. If the capital and interest coupon payments fall within normal business operations and are fungible with traditional “brown bonds”, how is that different? Looking at the underlying company is key.
We have already seen companies dispose assets at significantly reduced levels versus their book value
We have already seen companies dispose of assets at significantly reduced levels versus their book value, as BHP did with its coal assets.1 While this did not move spreads at the time, we expect this risk to become more prevalent and meaningful. It is destructive of the balance sheet, and more of these events will be part of the transition. There are companies ill-prepared to change, and we expect more stranded asset risk as tougher reforms come through. Some companies will have to make wholesale adjustments in a short period. That is likely to be more costly than incremental change, planned in advance.
How different is your approach to traditional IG strategies?
TC: We use the same benchmark, which makes it easier for clients to make allocations, but the way our model works is different to low-carbon or green bond strategies.
Our strategy is designed to have all the portfolio characteristics and use the same portfolio construction methodology as our flagship IG strategy, but with a strong climate ethos. Unsurprisingly, that is reflected in sector allocations, so we have a structural underweight to energy. That proved challenging last year given its performance, but we navigated the situation comparatively well. We also have an underweight to North American utilities because they are further behind on transition planning than European peers.
The way we take volatility into account allows us to allocate risk better
Where we differ is in portfolio construction and how we approach correlation. The way we take volatility into account allows us to allocate risk better. If a sector exhibits one level of volatility, we take corresponding risk elsewhere to mitigate it.
JV: Our approach allows us to access an investment universe whose characteristics are comparable to traditional IG strategies but viewed through a climate lens.
Every company is expected to be impacted by climate change through physical climate risk or the impact of decarbonisation; simply ruling out high-carbon emitters or investing in green bonds will not deliver the transition. All businesses need to adapt to the new reality.
That is why we invest in solution providers and transition leaders, companies improving their resilience to climate change across all sectors. If we only looked at solutions providers, we would have a restricted set of opportunities with limited sector diversification and different metrics. Our focus gives us a broader opportunity set in addition to amplifying the real-world impact.
The approach results in a more risk-aware portfolio
By managing a global credit strategy with wider reach than alternative green strategies, we have more arbitrage opportunities. It also means we can use our global IG portfolio construction capability, as Tom mentioned, which has a proven track record. The approach embeds careful risk allocation and downside protection delivered through custom sectors and stress testing, which results in a more risk-aware portfolio.
Have you made any portfolio changes given the new market regime?
JV: We are concerned with sticky inflation and expect growth to deteriorate, while central banks may need to keep rates higher for longer. At this point, the main risk is that the credit rally may have got ahead of itself, so we have been reducing risk and rotating some positions. We expect dispersion to remain high in this environment, leaving arbitrage opportunities for alpha generation.
We continue to prefer euro-denominated credit versus US credit from a valuation standpoint. We are overweight banks, which benefit from a higher rates environment and are relatively well-positioned for any recessionary pressures.
We focus on more stable companies less affected by the macro environment
On the other hand, we are cautious on cyclicals like autos and real estate and have reduced our exposure to BB-rated names. We focus on more stable companies less affected by the macro environment. From a maturity standpoint, curves are relatively flat, delivering limited compensation for longer duration, so we prefer short to intermediate maturities.
We also like climate solutions providers, particularly given the policy support for green capex. To give you some context, a Swedish battery maker recently said if it built a factory in the US, the tax credits would amount to around $8 billion by the end of the decade and cover around 30 per cent of operating costs. This is a big incentive. We believe large caps in specific sectors could be major beneficiaries of these trends and prove a source of resilience in market downturns.
What about your benchmark?
TC: We use a standard global IG benchmark, not one that is Paris-agreement aligned. When we launched the strategy, we could have used an ESG benchmark aligned to Paris but chose not to.
The Paris-aligned benchmark is a blunt tool. It has quite an aggressive low-carbon element, particularly in terms of European electricity generators. It excludes almost all that are active in the credit market. The restrictions are so tough they do not allow what we think is important, which is to back real-world transition.
If you exclude the worst emitters, it does not give them an incentive to change
There has been public criticism from commentators suggesting it could deny cheaper capital to companies starting from an environmental low point but moving towards doing the right thing. These are companies that could help contain global warming. If you exclude the worst emitters, it does not give them an incentive to change.
We also have exclusions but can override them if appropriate. Companies that generate revenues from fossil fuels are largely excluded using a filter defined by our climate pillar team. We can still allocate up to ten per cent of the strategy in companies that fail to meet the filter, providing they have clear transition strategies. Where we see companies making material changes, driving action we hope will help us avoid a climate catastrophe, we look to support them.
Engagement is key, in fixed income and equity, but there is no equity ownership in around one third of the companies in the fixed-income universe. Many of the world’s largest carbon-emitters are state owned or controlled, so there is limited capacity to influence through equity ownership. But investors in fixed income can support the transition and drive it in a way that is meaningful and tangible. That is why we think targeting net zero through comprehensive exclusions is not making the most of the tools we have.
Benchmarks that only include low-carbon companies are not necessarily inherently sustainable
One final point to flag is the recent downgrades from Article 9 to Article 8 of various ETFs making claims linked to carbon intensity.2 Benchmarks that only include low-carbon companies are not necessarily inherently sustainable; it’s something to be mindful of.
JV: The choice of a standard global IG benchmark also reflects our conviction companies that deal better with climate change are likely to outperform over the medium term. There should not be a trade-off between climate considerations and performance.
The trajectory of Paris-aligned benchmarks is achieved by exclusions and reallocating capital to low-impact sectors, as Tom points out. If having lower carbon intensity on paper in a portfolio is not reflective of what is happening in the economy, it is not going to solve the climate problem. Achieving real change requires tackling the highest-emitting sectors, encouraging companies to transition to greener business models by engaging with them and impacting the cost of capital of leaders and laggards.
It is also worth mentioning the flawed nature of the carbon-intensity measure, especially when it comes to Scope 3 emissions. Some solutions providers have a high carbon footprint and may get excluded, despite helping other businesses reduce their carbon load.
A metric like carbon intensity should not be the only criteria to assess a climate-conscious investment approach
Passive approaches that replicate these benchmarks are far from solving the systemic issue. They also offer limited protection to investors, as they do not take the investee companies’ planning against climate change into account. A metric like carbon intensity should not be the only criteria to assess a climate-conscious investment approach.
We back an active investment approach focused on risk and performance, which invests in solutions providers and companies in transition and engages with them, including those in high-carbon-emitting sectors, with reference to science-based targets (SBTs). We think it is an investment proposition that can deliver reward and impact, with potential for long-term capital growth, because you are investing in companies improving their emissions profile and resilience to climate risks.
Why do you prefer an approach backed by SBTs?
JV: It is important to address emissions of warming gases early because their half-life means they stay active in the atmosphere and will contribute to global heating for years. That’s why we need near-term SBTs that address emissions early and across the value chain. We need emissions reduction fast. As such, we target 90 per cent of exposure to companies with SBTs by 2030.
Near-term SBTs with a targeted engagement programme will be more effective at driving change
We think most companies are more comfortable looking at practical changes that can be made in the next five to 10 years, rather than net-zero commitments that can include offsetting and lack a clear strategy further out. Concentrating on near-term SBTs with a targeted engagement programme will be more effective at driving change overall.
TC: Net zero allows a lot of offsetting. There has been publicity recently about how companies are making net-zero commitments but are relying on poor-quality carbon credits to deliver it, which will not result in genuine carbon reductions.3 There are simply not enough assets available to generate the offsets people want or expect. Net-zero commitments like this do not stand up to scrutiny. Near-term SBTs are a more tangible way of assessing the state of play.
Do RePowerEU and the IRA mark an inflection point, where strong policy signals start to speed the transition? Can you see those changes reflected in the credit markets, in issuance and pricing?
JV: New solutions providers are coming to the market for the first time, driven by green policy initiatives. The names are not widely known and tend to offer better value. That’s the benefit of having an approach focused on corporate strategy, not just a green label or carbon intensity, which also gives us access a more diverse opportunity set.
The greatest impact is likely to be in the medium to long term
TC: We are seeing conversations around planning, but the greatest impact is likely to be in the medium to long term.
The scale of these initiatives is material; the numbers are big, but they need to be a lot bigger to achieve impact on a global scale. A few years ago, the UN suggested around $120 to $150 billion of investment is needed every year this decade to address climate change.
We have not achieved it in the first two years of the decade, and now we have inflation to address as well. We expect government support to increase rather than decrease, and that should continue to support the thematic.