Tackling ESG risks in fixed income and LDI

Most UK pension funds focus on improving the sustainability credentials of their portfolios through their equity allocation, but there is growing attention being given to incorporating ESG issues in fixed income and liability-driven investment (LDI) portfolios, too.

While investing responsibly means taking account of all relevant and material risks in portfolios as a whole, the lack of climate-based products in fixed income has affected the ability of investors to address climate risks in their government bond allocation.

"ESG risks occur across the whole of an asset owner's portfolio. Equities were the easiest for investors to tackle first, but now some asset owners are working on climate risk across their whole portfolio," says Ario Advisory founder Mike Clark.

Although not as immediately obvious as equities, pension schemes and their asset managers can address ESG in their fixed income and LDI portfolios in several ways.

Clark says, initially, the opportunities may be as simple as setting a mandate that reduces the portfolio's exposure to corporate bonds from companies that have high carbon risk.

"Do pension funds want their managers to be holding 10-or 20-year bonds from fossil fuel companies?"

Legal & General Investment Management (LGIM) senior solutions strategy manager Anne-Marie Morris says ESG principles can be incorporated by looking at bank counterparty and bond issuer selection; the investment of cash for liquidity purposes; and engagement with counterparties and bond issuers.

She adds: "Schemes may also want to include additional mandate specifications reflecting their own ESG values. For example, they may wish to target an initial temperature alignment for a buy and maintain credit portfolio with an objective to reduce this target over time towards a Paris aligned target - or maintain a minimum percentage allocation to green gilts within a LDI portfolio."

Insight Investment head of solution design Jos Vermeulen says, within its LDI strategies, the asset manager considers the profile of ESG risks borne by its derivative counterparties within its counterparty credit committee meetings.

"Our aim is to ensure that the ESG ratings of our counterparties are incorporated within our discussions with those counterparties, with a focus on those with the worst ratings," he explains. "To help our clients understand the ESG risks borne by their counterparties and how they are managed, we provide our ESG ratings for derivative counterparties to our LDI clients."

Insight focuses on how these ratings may affect the creditworthiness of its counterparties, and Vermeulen says "we seek to help our clients understand how these factors may be material for risk-management decisions".

Professional Pensions' parent company Incisive Media will host its inaugural Sustainable Investment Festival this summer to help schemes, trustees and advisers navigate this rapidly-evolving area of the market. Click here for more information.

The opportunity set

Investing in green bonds is another way to mitigate climate risks in fixed income, but while the green bond market is growing, it is still small with demand outweighing supply. As such, it is unlikely to make up a substantial part of pension funds' fixed income portfolios.

BlueBay Asset Management head of ESG investment My-Linh Ngo, says the emergence of the ESG-labelled debt market, in the form of use of proceeds (UoP) issuance - such as green, social and sustainability bonds - has provided limited opportunities to investors.

"While this market has seen material growth year-on-year, it has been from a low base, with projects hard to source and limited to specific sectors," says Ngo. "With the lack of supply leading to a relatively small secondary market, institutional investors can struggle to allocate in such strategies."

There has been a lot of hype around the UK's expected launch of its first green gilt later this year. But Morris says LGIM believes this is "only a very small part of how schemes should address ESG within these portfolios".

She says that irrespective of the bond label, ESG is integrated into all LGIM's investment decisions for its active credit funds and counterparty review policy.

"We will consider a company's ESG risks and opportunities alongside all other fundamental credit drivers. We therefore do not see portfolios that include sustainable bonds as necessarily having a superior ESG profile," she adds.

Beyond green bonds

Outside the green bond market there are other instruments, such as transition bonds, which are starting to gain interest as a concept.

"These bonds help investors to show they are encouraging ‘brown' industries to transition to lower carbon," says Ngo.

Another innovation in the market are sustainability-linked bonds (SLBs), which Ngo believes should be more likely to allow pension funds to invest with positive intent.

As she explains: "These can be issued by a broader set of entities and, by being outcomes focussed, there is potentially no limit to what and who can issue them. Not surprisingly, growth in SLBs is already growing, and likely to do so faster than the UoP category, signalling that SLBs will likely represent a larger part of the market in absolute terms over time."

Just because a bond has a label of ‘green' or ‘sustainability-linked', does not necessarily mean they are - and they are not all created equal.

For Ngo, it is a case of ‘buyer-beware'. She says: "Investors have to do their homework and check whether the projects or targets are credible and robust, and that reporting evidences the impact it is promising."

However, she insists that this market innovation is much welcomed and shows how markets can respond when the need arises.

"Given the size and nature of the fixed income market, they will be critical to enabling the much-needed sustainability transition," Ngo says.

Stephanie Baxter is a freelance journalist working at Rhotic Media

Sustainable Investment Festival, 22-25 June

Professional Pensions' parent company Incisive Media will host its inaugural Sustainable Investment Festival this summer, featuring keynote speakers, innovative breakout events and sessions to help schemes, trustees and advisers navigate this rapidly-evolving area of the market. Click here for more information.