Preparing fixed income portfolios for a net zero world

According to the IEA, spending on clean energy is set to reach $1.7 trillion this year, and that needs to rise to $4 trillion if we're to meet their net zero scenario.

And this is just spending on clean energy. There are other areas of the economy which need huge amounts of spend if they're also to decarbonise.

This creates a huge range of opportunities, and really exciting opportunities, for our investors. Particularly those investors that want to earn a return, but also want to support decarbonisation.

How could the long-term value of debt instruments be impacted by climate change?

Matt Henly: Environmental risks have the potential to cause fairly meaningful underperformance or outperformance of bonds, particularly in the highly energy intensive sectors.

We're already seeing this play out in the market today.

So if we take the utility sector, for example, the leaders in renewables are already starting to see their bonds trade more expensively than some of their similarly-rated peers.

Tom Hemmant: So this is a really important question, and it's relevant for all of the mandates that we manage – not just those with a climate objective.

Although I actually do think it's perhaps more of an acute problem for equity, where in certain sectors, there's real stranded asset risk that can affect them.

But it is an issue for bondholders. And I think that careful analysis and security selection is needed to navigate the risks.  

Matt Henly: The impact on companies’ bond valuations can come from fundamental factors.

So this could be the direct impacts of climate risks on a company's creditworthiness, but also technical factors. So changes in demand preferences for bonds. And in our net zero strategies, we're aiming to mitigate both of these risks for our clients.

Tom Hemmant: On a on a more positive note, I think I see the potential to earn superior risk-adjusted returns, if we can identify those companies that are going to be less affected by the negative trends around climate change. Or actually, preferably, those that are contributing positively to decarbonisation.

It seems to me that these companies have better sponsorship with investors. Because they have a positive long term structural story, I think that those bonds can be more stable over time.

Tom Hemmant: I would also note that there are commentators out there doubting whether we can ever reach net zero and querying the returns on renewable energy, for example. That's fine. And I agree that the road ahead is not always going to be straightforward.

But notwithstanding those doubts and those uncertainties, it's clear there's a big structural trend. There's a problem that needs addressing. And so I think there's still going to be a huge range of opportunities for us. And I think it's a really good area for active investors like ourselves to participate.

Is divestment an effective route to change?

Matt Henly: Divestment can play a part in net zero portfolios, but it needs to be for the right reasons. The essence of net zero strategies is identifying that high emitting sectors play an important role in the global economy, but that these sectors need to decarbonise, and they need capital to do so.¹

Our role as fund managers is to pick the best names within that sector, the climate leaders, to engage with them, to better understand their trajectory and to make sure they stick to the right path.

In our net zero portfolios, divestment occurs if a company deviates from that path – not simply because that company has a high carbon footprint today. And that's the key distinction to be made.

¹Note: This statement is relevant to the approach taken by some of Invesco’s net zero fixed income strategies, including the Invesco Net Zero Global Investment Grade Corporate Bond Strategy and the Invesco Net Zero Buy and Maintain Strategy. ESG investment strategies can vary, and not all of our ESG fixed income funds will follow the exact same approach.

Can you talk us through your credit selection process? How are climate considerations incorporated?

Matt Henly: To qualify for our net zero portfolios, three criteria need to be met.

We need to have comfort in the creditworthiness of the issuer. We need to see value in the bonds. And we need to have a strong conviction in the net zero credentials of that issuer. And what we mean by that is that we need to see a clear willingness and ability of that company to decarbonise along a net zero 2050 pathway.

The net zero assessments that we do are done for every single company that we invest in for our net zero portfolios, and they're carried out in-house using the strength of Invesco’s investment team, and the ESG team's research capabilities.

Tom Hemmant:

So the climate funds that we manage aim to support the transition to a low carbon economy and there are two elements to the credit selection for these funds. We use quantitative and qualitative analysis in order to ensure that the bond issuer meets the climate objective of the mandate.  

The quantitative analysis involves us scoring companies using a range of forward and backward-looking metrics, and then the qualitative analysis involves us doing some sort of deeper work to really understand the business and their plans. And this allows us to contextualise and interpret the output of the quantitative process.

In tandem to this work, we also analyse the financial risk-reward that is being offered by the bonds. Simply put, are our investors being paid enough for the risks that they're taking on?

How can investors implement climate-conscious strategies through ETFs?

Sam Whitehead: ETFs typically passively track the indices. Climate considerations can be incorporated in much the same way you'd incorporate broad ESG metrics.

For some ETFs, the indices they track can use a tilting approach or a best-in-class approach. And that might be based on carbon emissions, or it might be based on a low carbon transition score of some kind.

So the ETF might look to overweight companies which are solutions, and underweight those which will have their assets stranded in the future.

Another unique feature of bonds, which ETFs can take advantage of, is the time exposure for investors is limited. This is different to equities, where you'd have to sell to disinvest.

In this case, you can look to reinvest those proceeds in an issue which more closely aligns with a target portfolio that your ETF is looking at on a rules-based approach.

Hence, you see improvements in climate considerations over time.

Tap into opportunities as the world prepares for 2050. Discover our range of climate-conscious fixed income solutions.