Thomas Chinery and Justine Vroman discuss current conditions in the investment-grade market, the ECB’s “green QT” programme, and why oil and gas firms must go further and faster to decarbonise.
Read this article to understand:
- The effects of macroeconomic uncertainty on investment-grade bond markets
- How shifts in the European Central Bank’s balance sheet could influence the climate transition
- Why sustainability-linked bonds represent opportunities despite investor scepticism
Summer 2023: welcome to the inferno.
According to the World Meteorological Association, July will be the hottest month in recorded history.1 Parts of China and the US topped 50 degrees Celsius. Flash floods caused devastation in South Korea. Holidaymakers stuffed their suitcases and fled wildfires on Greek islands.
Scientists have concluded such extreme weather events would have been “virtually impossible” without human-induced climate change.2 As the reality of global warming hits home, the imperative to tackle carbon emissions is becoming ever more urgent.
The debt markets have a major role to play in this process. The energy transition is set to cost anywhere between $3.5 trillion and $9.2 trillion a year and bond issuance will be key to raising the necessary financing.3,4
Recent months have seen progress on important initiatives. The European Central Bank (ECB) is undertaking “green quantitative tightening”, reducing its €5 trillion bond portfolio while making partial reinvestments in bonds from firms with good climate credentials. The continued rise of sustainability-linked bonds (SLB) – whose payment terms are based on key performance indicators connected to business-level objectives – is providing companies with a useful climate financing tool.
At the same time, bond investors are grappling with wider market challenges, notably the rise in interest rates and volatility in the financial sector. In this Q&A, Justine Vroman (JV) and Thomas Chinery (TC), co-managers of the Aviva Investors Climate Transition Global Credit strategy, discuss how macroeconomic uncertainty is influencing their positioning and the risks and opportunities for climate-focused bond investors over the coming months.
Does the extreme heatwave illustrate the need to accelerate the energy transition?
TC: It is a horrible proof-point that climate change is already here. Given this, it is dispiriting that climate scepticism persists in some media outlets and in the rhetoric from certain politicians, particularly in the US, despite new temperature records across North America and elsewhere.
There was previously a view US companies were well behind European counterparts on climate
But there are reasons for optimism. Whereas there was previously a view US companies were well behind European counterparts in the way they sought to address climate change, our engagements suggest the gap is closing. Many US utilities firms, for example, are building serious capital expenditure plans to cut emissions and build resilience to climate risks.
What have been the key developments in investment-grade credit markets since we last spoke and how is that informing your positioning?5
JV: Inflation has been stickier than expected, which has led to higher rates and a resurgence in interest-rate volatility. Certain business models have become exposed as rates have risen. But many economies have proved more resilient than anticipated and uncertainty over the economic cycle continues.
Our structural view remains negative – we think credit spreads are likely to widen in the second half. But over the last few months, we have been able to dial up and down overall risk to take advantage of tactical opportunities. We will continue to do this.
We view the higher-yield environment as compelling for the asset class
Overall, we view the higher-yield environment as compelling for the asset class – it means bond investors are better able to absorb short-term volatility and still expect a positive total return.
TC: Among the biggest events in the first half was the banking crisis. While three US banks failed, the forced merger of Swiss giant Credit Suisse with UBS was arguably more significant. Positively, the reaction function from central banks and regulators was swift and effective. All told, the period of volatility stemming from the failure of a systemically important global bank was only around three weeks.
Trading can be difficult during short-lived volatility events because the market tends to move in one direction – widening when the panic starts, then tightening as soon as investors get some comfort. Although our strategy is overweight on banks, we were confident in our stock selection and these holdings have made a positive contribution to the strategy’s performance year to date.
How would you sum up the performance of the strategy this year?
JV: Last year was a good test of the downside protection we embed in our strategy, and performance was resilient despite the market turmoil of 2021. Although the strategy lagged the benchmark slightly, it performed well compared with peers due to active risk management and lower levels of volatility.
Our overweight position in banks is among the key drivers of performance
This year has been about capturing upside and carry. Despite the uncertain macro environment and volatility in the financial sector, the strategy’s performance is positive year to date. Our overweight position in banks, along with our exposure to euros and sterling credit (currency-hedged), are among the key drivers.
The strategy is underweight energy, and we've given up some performance due to our exclusions of certain carbon-intensive names. But this is more than balanced out by strong performance among our investments in climate-solutions providers, in sectors such as capital goods. Green capex policies among major companies, along with policy initiatives such as the US Inflation Reduction Act and EU Net Zero Industry Act, have provided thematic tailwinds for companies in this area.
Where are you seeing opportunities?
JV: After the events of the past few months, valuations among banks are looking more attractive and we see some scope for further spread compression in the sector.
We still have a slight preference for the euro over the dollar
In terms of currencies, we still have a slight preference for the euro over the dollar, but the valuation argument is less compelling that it was at the start of the year. Given the uncertain economic outlook, we continue to prefer companies in less-cyclical sectors such as telecoms, utilities and healthcare. Overall, we prefer higher-quality, defensive names. We expect dispersion to increase, leaving arbitrage opportunities for alpha generation.
We remain wary of some real-estate issuers: the sector has outperformed recently, but there could be further challenges for owners of offices given the rate environment and structurally lower demand in a post-pandemic world.
Where are other areas of weakness?
TC: Lower-quality companies with higher leverage are likely to face more stress to their balance sheets, particularly if they have to refinance at higher levels of interest. The investment case for these kinds of firms depends on the mitigations they can offer.
Lower-quality companies with higher leverage are likely to face more stress
For example, retail companies have been good at passing through prices to customers, because consumer spending has stayed broadly resilient across developed markets. But if that starts to change, you might see some of the more highly levered, cyclical names in that sector come under stress.
Since February, the ECB has been reducing its portfolio and making partial reinvestments in companies with good climate credentials, under the so-called “green QT” programme. What impact has this had?
JV: The pricing impact so far has been relatively limited. Reinvestments at the overall level have only been cut by an average €15 billion per month between February and June and will be stopped from July. The programme is currently flow-based; if the ECB switched to a stock-based approach, and more actively rebalanced its corporate portfolio by selling out of climate laggards as well as buying bonds from greener issuers, that would likely have more of a pricing impact. However, we would expect overall volumes to remain in check. That is the logical next step, and there are signals the ECB may be considering it.
We would welcome a more active rebalancing programme by the ECB
We would welcome a more active rebalancing programme, which would reward European companies that are proactive on climate while providing an incentive for firms in sectors such as real estate and automotives to do more to cut emissions and outline clear transition plans. The ECB considers not only greenhouse-gas emissions but also climate disclosure and carbon-reduction targets, which aligns with our own transition-focused approach.6
What are your views on sustainability-linked bonds (SLBs)?
TC: We like the SLB structure. It chimes with the way we think about companies’ transition plans. Whereas green bonds are “use of proceeds” securities – they raise financing for a specific project – SLBs seek to align a company’s whole business model with a sustainable agenda. The SLB market is also open to a greater range of issuers, such as smaller companies that may struggle to issue green bonds because the project being financed does not qualify for a benchmark-sized issuance.
However, there is understandable investor scepticism about SLBs, particularly when it comes to a lack of ambition in KPIs – in some cases, KPIs have been effectively met at issuance – and a lack of materiality in the coupon step-up if the targets are not met.
There is understandable investor scepticism about SLBs
It is worth keeping an eye on the SLB from Italian energy firm Enel, whose KPIs on reducing emissions are due to be assessed at the end of this year. There is a chance the company will miss its targets due to knock-on effects of the war in Ukraine. That would be a test of the credibility of a major issuer and the SLB market.
One way for the corporate SLB market to grow and gain more credibility would be for issuers to increase the materiality of the coupon step-up when they fail to meet KPIs, in line with the rise in interest rates. This would give companies more incentive to meet their targets and investors more of a case to add SLBs to portfolios.
Eighteen months on from Russia’s invasion of Ukraine, how do you assess how countries are responding to energy security pressures and where does this leave the transition to renewables?
TC: Concerns over energy security are driving greater demand for renewables because each country can enhance its independence by building renewables capacity. The benefits can be environmental and economic. Figures from the International Energy Agency (IEA) show consumers in the European Union are due to save almost €100 billion in cumulative energy costs by December 2023 thanks to the accelerated roll-out of renewables capacity since the war in Ukraine began (Figure 1).
Figure 1: Cumulative electricity costs saved as EU solar and wind capacity is added, 2021-2023
Source: IEA, 2023.7
However, balancing energy-security objectives with immediate energy needs and longer-term net-zero goals can be tricky. One reason why Enel’s SLB might miss its emissions KPIs is because the company has had to keep coal-fired plants open to ensure Italy has the power it needs while it builds wind- and solar-power facilities and switches away from Russian gas. That provided 40 per cent of its electricity-generation needs before the invasion.8
Adding further complexity, renewables companies are struggling with rising supply-chain costs, which can be a problem if they have already agreed to electricity contracts at a lower price than the current market level. For example, Swedish group Vattenfall in July announced it was suspending work on an offshore windfarm in the UK, citing a rise in materials costs that renders the project uneconomic.9
UN secretary general António Guterres recently criticised the oil and gas sector for focusing on unproven carbon capture, usage and storage (CCUS) technology rather than adopting credible transition plans based on existing methods.10 Does he have a point?
TC: If we are to tackle climate change, it is not enough for companies to simply reduce their emissions; we need all the tools in the arsenal, including CCUS.
It is not enough for companies to simply reduce their emissions; we need all the tools in the arsenal, including CCUS
It is true this technology is nascent; although it is proven to work, it is not yet commercially viable at scale. But we would not wish to dissuade companies from developing these solutions. Many firms working on them are oil and gas companies with a strong commercial incentive – as well as the requisite cash and research-and-development budgets – to make them viable over the longer term.
However, when it comes to reviewing these companies as potential investments, we have not yet found any with sufficiently rigorous transition plans to make them eligible – even though our strategy aims to support companies in polluting industries that are moving in the right direction. Globally, only around ten per cent of oil and gas companies’ capex is going towards low-carbon activities. While we respect these firms’ efforts to develop CCUS technology, the sector is not moving far enough, fast enough.