This podcast explains why investors should consider climate transition strategies for fixed income portfolios and why existing strategies use a variety of indexes as a benchmark for climate offerings.


Martijn de Vree: Our view is in favor of a broad market index. We believe these investors should really consider market indices as a viable alternative.

Catherine McLaughlin: That is Martijn de Vree, head of Fixed Income Solutions at Allspring Global Investments. And I am Catherine McLaughlin, head of institutional Sales for the U.K. and Ireland, and you’re listening to On the Trading Desk®. Joining me today is Martijn de Vree, head of Fixed Income Solutions at Allspring Global Investments. On this podcast, we’ll be discussing why investors should consider climate transition strategies for their fixed income portfolios and reasons why existing strategies use a variety of indices as a benchmark for climate offerings. Thank you for being here today, Martijn.

Martijn: Thanks for having me.

Catherine: I’d like to start with a broad question, but a primer for our conversation today. Many investors when considering climate transition strategies for portfolios, historically looked at equity allocations for meeting climate objectives. Why should investors prioritize climate transition strategies in their fixed income portfolios, as well?

Martijn: Great question. We have seen lots of good progress on the equity side and, increasingly, investors see the importance of prioritizing climate transition across their whole investment portfolio, including fixed income. Did you know fixed income markets have, on average, a higher carbon intensity compared to equities? Not everyone knows this. And this really shows how an increased impact can be made on decarbonization. Or another interesting fact, over 60% of climate finance over the last decade has actually been sourced in the form of fixed income, which is way more compared to equity financing. And we expect this to remain. Now, you might say equity investors own companies. They have voting rights and have outcomes that are fully aligned with those of the issuer. However, fixed income investors are susceptible to defaults and downgrades. And in the absence of ownership, they can still have a profound influence over companies. This is especially the case for investment grade holdings of large-cap firms, which depend vitally on efficient financing. And each time they come to the markets, it’s really an opportunity for us to engage in climate and other pressing issues and then decide whether we’re going to refinance these companies or stay away. Then, from a financial perspective, with yields where they are today, investors are really being rewarded for providing financing in the form of fixed income. And we at Allspring Global Investments really see climate transition as a source of investment alpha, aiming to do better compared to the broad markets. And allocating capital to companies that are actively positioning themselves for a net-zero world can really help to potentially increase the probability that investors will actually receive the expected coupon and redemption payments. And our goal is to risk manage the impact of climate change and also invest in companies that are on the right side of change, benefiting from the climate transition. So, altogether, it’s fair to say fixed income is really key for climate transition.

Catherine: Thank you Martijn. Those are some really interesting points. Now, you recently published a blog alongside our colleague, Tom Lyons, who’s head of Climate here at Allspring, on the topic of choosing an index with climate transition fixed income investing. Can you give our listeners an introduction to this topic, please?

Martijn: Yes, definitely with pleasure. Climate transition strategies, in general, but also specifically for fixed income investors, to implement these, you have some challenging questions. And among the most important really is which index should we use? Now, Tom, myself, and the team, we put our brains together. We’ve written a blog that you mentioned. And what we’ve done in there is, first of all, we reviewed which indices are commonly used today by fixed income investors with climate objectives. Secondly, we made a comparison of standard market and some climate indices that are mostly used. And finally, we looked at the benefits of using a standard market index versus other indices. And what we really found is that today most indices are measured actually against standard market index. And there are still some that are using either a Paris-aligned or, for example, a green bond index. Now on the latter, on the green bond index, from an investment perspective, the green bond universe is really only quite a small subset, about 8% or so at the moment of the standard market index, and that means that at least quite different investment metrics. For example, yield is a bit lower, but, perhaps surprisingly, when you look at carbon, the carbon intensity of green bonds actually tends to be quite a bit higher compared to the market. And what is really behind this is the fact that carbon intensive polluters or polluters issues tend to dominate green bonds. Although it’s a really interesting area, in our view, the narrow focus of green bond indices makes them a little bit impractical as a benchmark for most institutions that invest in the broader climate transition markets. And it start to make us really focus on the relative merits of Paris-aligned and broad market indices. Now a bit more on Paris-aligned indices. A Paris-aligned index is a broadly exclusions-based approach that will effectively achieve decarbonization through strict emission caps, basically excluding companies with the highest emissions. And S-Carbon contribution can be quite concentrated. And exclusions, therefore, can be really effective to achieve decarbonization of an investment portfolio. And I’ll give some numbers to illustrate it. When you look at all markets, if you only exclude the top 1% of emitters, you get a whopping 22% reduction in carbon intensity. And if you only exclude the top quartile of emitters, so the top 25%, what your left over with is a resulting portfolio that has 90% less carbon intensity. So, this really demonstrates how easy it is to decarbonize a portfolio. However, it is arguable that excluding companies based on their historic carbon emissions does anything to the real economy, to -future decarbonization, and therefore, we suggest investors to think carefully about which index to use.

Catherine: It sounds like an exclusions-based approach might present tradeoffs for investors. What are a few of those tradeoffs that you can share?

Martijn: That’s right, Catherine. Let me share two key tradeoffs. First of all, contribution to change. And what I mean there, I’ll illustrate with some research we did. We identified the largest contributors to decarbonization within the fixed income markets over a certain period of time. And then, we looked at which companies achieved the largest decrease in carbon footprint. What we found was really interesting because all the companies in the top 10 of contributors were those with very high initial emissions, each with intensity in excess of 500 metric tons of co2 per million dollar of revenue, a metric that we use to look at carbon intensity, which is pretty high. It’s easily more than double the average of the index. And this really illustrates how to highest emitters today that are on a clear path towards decarbonization can really make an outsized contribution to reductions in carbon intensity. So, put it another way, we should not focus on investments purely based on today’s low emitters, if we want to invest in decarbonization and make an impact in the real economy. And maybe the second key tradeoff is around clarity. When looking at climate indices, there’s a growing geniality amongst climate-focused indices, whether they’re focused on climate change, or emission carbonization, the EU (European Union) Paris Alliance, or climate-resistant indices, or green bonds, there’s quite a few out there. And we believe that the market is thinking about what is the right index. And each index’s pros and cons are still evolving. And in our view, these indices often rely on imperfect data, processes, and are based on predetermined rules. On the other hand, as a tradeoff, the broad market index perhaps provides more clarity. And it also really allows investors to overlay their own objectives.

Catherine: Sounds like the approach to the benchmark can have a real impact. Are there any other investment considerations that you might highlight to our guests today?

Martijn: When we speak with investors looking for broad fixed income exposure, they are looking for diversification across geographies, ratings, and sectors. And what we have seen with an exclusions-based approach is that portfolios tend to result in unintended sector concentrations due to the sometimes blunt exclusions approach being adopted. To pick an example, banks tend to be a large proportion of the investable universe already and this is even more so for Paris-aligned indices with their strict exclusion-based approach.

Catherine: Much appreciated, Martijn. And finally, with the time we have left, can you provide the conclusions or insights on Allspring’s approach to this topic of choosing an index for climate transition fixed income investing?

Martijn: Yes, definitely. After the research that Tom, myself, and team have done, we outlined key tradeoffs and we made a case for carefully considering which index to use when managing climate transition portfolios. And our view is in favor of a broad market index. And it might not be controversial as most climate-aware fixed income strategies today already use a market index. However, we observe that there are many equity investors who use climate-focused investment strategies as are increased number of fixed income investors, especially looking at, for example, trackers or passively managed products. It’s for the reasons outlined above that we believe these investors should really consider market indices as a viable alternative.

Catherine: Thank you, Martijn, for being with us today and for sharing your insights.

Martijn: It was a pleasure.

Catherine: And for our listeners, thank you for joining us here On the Trading Desk®.

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Disclosure: 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). [Alpha is based on historical performance and does not represent future results.] Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

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