Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why fixed income is sustainability’s new frontier
While pension funds around the world “have done a lot of work” on climate in and with their equity portfolios, they’re now looking to affect more change with their fixed income allocations, says Henrietta Pacquement (pictured), head of global fixed income at Allspring.
“We’re increasingly seeing investors taking a more sophisticated approach,” Pacquement says. “There’s more data coming out as a result of companies publishing their climate strategies, and I think there’s more of a focus on not just decarbonising the portfolio but decarbonising the real economy. What impact are we having through our investments? How can we facilitate the transition, and how can we be cognisant of the physical risks that might impact the portfolio?”
Last Summer was an “eye opener” in terms of the consequences that climate change can and is starting to have. And while equities grant voting rights, and engagement is hardly dead, investors have realised that they need to look at their whole portfolio through the lens of climate. Data in fixed income has improved, and there’s “more subtlety”; there’s also the opportunity to engage with companies when they come to the funding markets. There’s also been significant innovation in styles of bonds, including green, blue, transition and sustainability-linked bonds.
“In terms of thematics the big one is climate related, because it is such a fundamental change and is something that is reasonably measurable in of itself; you can look at your carbon footprint or intensity as something you can hang your hat on more than other sustainability topics,” Pacquement says. “But we’re hearing a lot more about biodiversity, and you have the Taskforce on Nature-related Financial Disclosures coming up.”
“Modern slavery is another area where we’re having more and more conversations… It’s going hand in hand with what we’re seeing from the companies themselves. If you look back ten years ago, sustainability and climate would not have featured in a bond roadshow. They definitely do now.”
Allspring has “significantly increased” its engagement with companies, and companies are also coming to them for guidance on new bond issues; some aren’t aggressive enough or have targets that are “already thoroughly baked into their strategy”.
“We’ve had situations with some utilities that had some nice coupon step-ups that hit the year before the bond matures and the target isn’t particularly aggressive, so they’re not really making enough of an effort,” Pacquement says. “There’s a bit of exploration in terms of what they’re looking to achieve and whether it’s something that is easy to measure or something that’s easy to appreciate as a bond holder.”
“We’re seeing a fair amount of innovation there; we’re looking at an issuance now in the high-yield space and they’re giving targets on some of their downstream providers. Is that a sensible one to have? How much control do you have? The intention is good and it’s going in the right direction, but is that something that makes sense to have as a KPI in a bond?”
And while the temptation is always there to divest certain bonds in the energy sector, Pacquement asks if it’s “really the right approach”. In the utilities space it’s easy to put a blanket exclusion on coal power, but investors have to be “cognisant of a fair transition”, the need to maintain energy security in the aftermath of the Ukraine conflict, and the fact that a number of companies do now have credible plans to shut down their coal plants.
“Do you want to support those utilities, particularly if they’re big investors in the renewables space? Yes, you probably do. It’s about how you build a portfolio that makes sense, taking into account climate considerations without cutting your nose off to spite your face.”
