This blog is the first in our new Climate Transition 2023 series, which focuses on the emerging climate transition opportunity in fixed income.
What is climate transition credit?
To maintain the global temperature within levels specified under the Paris Agreement, rapid, large-scale decarbonization is needed. It is no surprise then that significant changes across a range of companies will also be required to pursue this goal. As such, investors should consider their portfolios now and align for future changes and innovation in bond structures to be on the right side of this transition.
We believe that investors can pursue their climate objectives while maintaining their financial goals—it is no longer an either/or proposition. To do so effectively, we advocate for the use of market benchmarks rather than a Paris-aligned benchmark to give investors an inclusive and true reflection of the opportunity set.
Why fixed income for climate transition?
Equity investors own companies, have voting rights, and have outcomes that are fully aligned with those of the issuer. Bondholders, on the other hand, lack the same degree of alignment with the issuer. However, bond holders are susceptible to defaults and downgrades and, even in the absence of ownership, can still have profound influence over companies. This is especially the case for investment-grade holdings of large-cap firms, which depend vitally on efficient refinancing.
So, why should we focus on fixed income when we aim to act for climate transition? We point to three reasons:
- Financial return: Allocating capital to companies that are actively positioning themselves for a net-zero world can help avoid stranded assets and potentially increase the probability that investors will receive expected coupon and redemption payments.
- Carbon intensity: As shown in the chart below, the average weighted carbon intensity of fixed income can be higher than main equity indexes. As such, fixed income assets can be a key tool in the decarbonization arsenal.
- Engagement: Bondholders can make a difference through active engagement. This gives investors in credit a real opportunity to drive change. Access to capital and cost of capital are powerful levers for bondholders when engaging.
Why is this important for investors?
While companies in all industries are considering the need to position for climate transition, the specific issues faced by each company can be unique. However, there is a universal need to adhere to financial goals, respond to regulatory pressure, and perhaps acknowledge the growing consensus that decarbonizing the real economy is the “right” thing to do. Below we show a few examples of motivations we have heard from our clients:
“Our clients want to gain income while contributing to making the world a better and cleaner place.” —Private bank
“We have increasing pressure from our members to invest sustainably.” —Defined contribution pension scheme
“Regulation forces us to consider and keep capital against climate risks.” —Insurance company
“We want to invest in climate transition while generating cash flows to pay members.” —Corporate pension plan
How do you invest in climate transition credit?
As an active manager, it will come as no surprise that we believe you need to truly understand the fundamentals of a company before investing in it. Using our Climate Transition Framework, our fundamental analysts draw and build upon their deep knowledge of the bond issuer to evaluate and score the implications of climate change on company fundamentals, resulting in portfolios geared toward climate transition.
While decarbonizing the real economy may be the “right” thing to do, forward-looking climate insights can also establish an informational edge over what is readily available in widely followed databases and they can present alpha opportunities. In our view, a deep understanding of climate exposure based on fundamental credit research helps us manage risk and invest in companies that are in our view are transition leaders geared to be future winners.
We seek to balance financial and climate objectives in order to create globally diversified portfolios that are grounded in fundamental research. The aim is for net-zero carbon by 2050 with an immediate, significant reduction in intensity and a constant focus on sustainable outcomes. This is demonstrated in our Climate Transition Decarbonization Trajectory below. Allspring also accommodates investors with more ambitious goals prior to 2050 and helps them understand the trade-offs between more ambitious decarbonization plans and a need for a “just” transition.
What’s next?
Look out for our next piece entitled “Burning Questions in Climate Investing” (PDF) to find out more about the tough questions on investors’ minds.
Alpha measures the excess return of an investment vehicle, such as a mutual fund, relative to the return of its benchmark, given its level of risk (as measured by beta).
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