Aligning Fixed Income Portfolios to Net Zero

    by Manan Mehta, Northern Trust Asset Management

    With COP26 having just passed, asset owners are pursuing long-term sustainable investment with more conviction than ever, further exploring how to factor in climate change, a path to net-zero and the financial risks of remaining on the sidelines. This is true for fixed income portfolios where climate-related transition and physical risks may impact investment returns. However, a naïve approach to integrating climate change in investment portfolios will bring about unintended consequences.

    Manan Mehta, Head of Quantitative Fixed Income Research, Northern Trust Asset Management

    That said, it is very difficult to model negative credit implications associated with climate risks. As the first level of defense, investors are integrating climate risk in their fixed income portfolios by looking at three elements: decarbonization, corporate engagement, and tilting portfolios toward climate solutions. At the same time, fixed income investors are incorporating considerations for long-run bond returns, such as duration, yield, sector and country risks. Increasingly, investors are also seeking to capture fundamental credit investment opportunities by systematically targeting compensated risk factors such as value and quality.

    The Two Dimensions Of Financial Risk In Climate Change: Transition and Physical Risks

    COP26 increased the global financial community’s emphasis on disclosure of the environmental risks discussed earlier by the G20 Financial Stability Board Task Force on Climate-related Financial Disclosures (TCFD). TCFD segments climate-related risks into two categories — transition and physical risks — that can be addressed through our three-pronged approach that we explain below.

    Transition risks are generated by policy, technology, market and regulatory changes likely to accompany the transition to a low carbon economy. For example, some assets may become “stranded” when they become less valuable due to their inability to adapt to a low carbon economy. As much as 42% of today’s publicly listed utilities’ coal capacity is losing money. Further cost pressures could make 72% of the coal power plants’ capacity cash flow negative by 2040. Physical risks affecting property, plant and equipment can be event-driven (e.g., hurricanes, wildfires, and floods) or due to chronic longer-term shifts (e.g., sea-level rise, heat stress and water stress) in climate patterns. This includes, for example, the 2019 to 2020 Australian wildfires that scorched more than 46 million acres and hurt tourism and farming.

    Addressing Climate Change Risk In Credit

    We believe that environmental, social, and governance (ESG) risks will negatively affect fixed income prices over the long run but uncertainty remains around the timing, nature and magnitude of such risks. Evidence is somewhat mixed on whether bond markets are pricing in ESG uncertainties in credit spreads for environmentally harmful “brown” companies versus “green” companies after controlling for credit rating, sector membership and credit term structure. There is a modest premium for green as measured by option-adjusted spreads (OAS) across four metrics[1]. Higher rated ESG issuers tend to command a spread premium (a tighter spread) than lower-rated ESG issuers.

    Given these relationships between better ESG ratings and spreads, it isn’t recommended to simply invest in top-rated ESG companies or to exclude some industries. As discussed in our “Sustainable Investing in Fixed Income: Avoiding the Pitfalls” article, this naïve approach could bring unintended yield, duration, sector and country risks2. Investors should take intentional risks, and ensure they are compensated for those risks, to achieve the outcomes they seek. That’s why we believe in taking a three-pronged approach to investing in corporate bonds inclusive of sustainability or climate-related goals.

    Lower The Carbon Footprint In Bond Portfolios Without Increasing Risk

    Lowering the carbon footprint of a portfolio will reduce transition risks because lower carbon footprint companies are less exposed to the risks of not achieving the “1.5-degree scenario,” which calls for holding the increase in the global average temperature to 1.5 degrees Celsius above pre-industrial levels.

    To achieve this, current aggregate world greenhouse gas emissions must be halved, according to the World Bank [3], requiring significant policy and regulatory changes. This would likely expose companies with higher carbon emissions to higher transition risks than their competitors with lower carbon emissions. A Harvard Business Review article suggests that “Carbon Might Be Your Company’s Biggest Financial Liability [4]. ”For example, companies with high carbon footprints will suffer financially as more countries assign a price to carbon emissions and as carbon pricing becomes more expensive. This could cut the earnings of companies with high carbon emissions.

    Some estimate that most institutional portfolios are currently invested for an implied temperature rise of roughly 4 degrees C [5]. How can institutions lower this significant risk? A balanced approach favouring low carbon leaders within sectors — rather than fully divesting from sectors and companies — can facilitate meaningful reductions in the carbon footprint while also considering key fixed income risks, such as duration, yield and sectors.

    Exhibit 2 shows carbon attribution for portfolios of global investment grade and global high yield bonds, respectively, that target a 50% reduction in carbon intensity. We decompose the carbon intensity of the portfolio with respect to the benchmark into an allocation and selection component. Selecting low carbon leaders can achieve 86% of the desired overall reduction within global investment grade and 63% of the overall carbon reduction in global high yield portfolios, respectively. Because investment-grade bonds tend to have less exposure to carbon-intensive sectors, it is not surprising that it is easier to achieve a higher carbon footprint reduction in investment-grade bonds from selection rather than allocation.

    This exhibit may make it seem as if one can simply choose the lowest-carbon companies for fixed income portfolios, but investors should not overlook other sources of risk. A better approach is a risk-efficient portfolio optimization that controls for exposures – such as duration, spread, sectors and issue-specific risks — while improving issuer selection through the use of compensated factors, such as value and quality. This risk-controlled approach can be paired with the objective of targeting a carbon footprint reduction to produce better overall portfolio outcomes.

    Engage With Companies On Climate Change

    Through Stewardship Long-term asset owners are engaging with issuers across asset classes and geographies to foster sustainable business practices in their portfolios. Specifically, from a net-zero alignment perspective, asset owners are looking to engage with actors including credit rating agencies, auditors, stock exchanges, proxy advisers, investment consultants and data and service providers to accelerate the transition to net-zero and reduce emissions in the real economy.

    Like equity investors, fixed income investors are examining whether companies have clear net zero carbon targets and strategies, as well as capital expenditure plans to support the transition to net-zero. They are engaging with companies as part of coordinated dialogues, including the Climate Action 100+ (CA100+) initiative and using CA100+’s Net Zero Benchmark assessment framework to drive their engagement agenda. More than half (52%) of CA100+ companies have announced their ambition to achieve net-zero by 2050.

    Considering Company Moves Toward Climate Solutions

    Focusing only on the historical carbon intensity of a company doesn’t give a complete picture of companies’ potential climate risk because it doesn’t incorporate what may happen in the future. For example, a company’s carbon intensity may increase or decline with future capital expenditures. Accordingly, investors are increasingly focusing on the extent to which a company manages risks with future challenges related to climate change and captures opportunities while transitioning to a low carbon economy.

    There is a continuous need for innovation in portfolio management techniques. To that end, we believe that sustainability and climate change initiatives represent an important opportunity. Improvements in ESG and related datasets make the systematic integration of these considerations possible in fixed income portfolios [6].

    In summary, modelling risks and uncertainties associated with future climate change and its impact on asset prices requires a sophisticated approach. Systematic investing approaches that retain flexibility and allow managers to incorporate considerations on sustainability and climate change in their fixed income portfolios can create the potential for better risk-adjusted returns over the long run. These findings are not only intuitively and economically appealing, but they also stand on the shoulders of decades of empirical research. When every basis point of return matters and opportunities to generate income are challenging, we believe investors should strongly consider a systematic approach to fixed income investing.

    [1]  The four measurements are the Northern Trust ESG Vector Score, a measurement that assesses publicly traded companies in the context of financially relevant environmental, social and governance (ESG) related criteria that could impact their operating performance for further reference refer to https://landing. ; MSCI ESG Score, a measurement designed to measure a company’s resilience to long-term, industry material ESG risks, which uses a rules-based methodology to identify industry leaders and laggards according to their exposure to ESG risks and how well they manage those risks relative to peers; ISS Scope 1 and 2 carbon intensity; and the ISS carbon risk rating score, which assesses the climate-related performance of companies, taking into account not only industry-specific challenges and risk profiles, but also considers companies’ positive impact.

    [2] Northern Trust Asset Management, Nov 19, 2019, a442e8bc80a4 companies,

    [3] Emissions Gap Report 2021,

    [4] Robert G. Eccles and John Mulliken, Oct. 7, 2021.

    [5] UNPRI, Net Zero Investment Consultants Initiative (NZICI): Guidance and Q&A,


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