Investing for environmental or social impact within the constraints of traditional benchmark-driven fixed income markets is a daunting challenge. It is inherently difficult to avoid high emitting sectors or companies, or to provide evidence of measurable social impact via benchmark issuers. The solution, according to BlueOrchard’s Head of Public Debt Portfolio Management Evariste Verchere, is to focus on emerging markets and create a new benchmark-agnostic perspective.
Zürich-headquartered BlueOrchard has been seeking to provide its clients with profits with purpose for over two decades, and since its integration with the Schroders Group in 2019 Verchere and his team have been able to complement their in-house resources with those of the Schroders global fixed income platform. Verchere explains why BlueOrchard believes that benchmarks are essentially incompatible with impact investing in listed fixed income: “While traditional funds use a benchmark to define their investable universe, impact funds must build their set of available investments based on their ESG or impact criteria. Since benchmarks are not replicable, particularly when their universe includes sectors that may not align with these criteria – for example, the oil or mining industry, the portfolio manager needs to start with a blank sheet of paper. Although this is challenging, it also means that by being agnostic, the portfolio manager can focus more on diversification and accurately reflecting their market view, rather than solely relying on the availability of bonds.”
BlueOrchard implements this approach in two open-ended article 9 funds. The Schroder ISF BlueOrchard Emerging Markets Climate Bond (CBF) and the Schroder ISF BlueOrchard Emerging Markets Impact Bond (IBF) seek to address climate change and financial inclusion respectively. Nevertheless, this environmental and social impact must be delivered alongside healthy financial returns for BlueOrchard’s clients. How do Verchere and his team manage this dual requirement? He once again points to the flexibility of their strategies, which enables them to generate alpha from multiple angles: “As we are not bound by a benchmark, we can enhance the quality of our issuers and reduce the duration of our bond portfolio when the environment is challenging. We can also capitalise on views related to countries and factors, generating alpha from relative value when opportunities arise. This flexibility allows us to make the most of current market conditions.” However, for these strategies BlueOrchard hedges all currency exposure to limit volatility, as the risk premium associated with foreign exchange rates is questionable, according to Verchere.
Accurate measurement and reporting of non-financial outcomes has long been a problematic area of impact investing. With this challenge in mind BlueOrchard set about building a proprietary impact management framework. The B.Impact framework provides mapping and alignment to the United Nations Sustainable Development Goals (UN SDGs) at investee and fund level. As well as standardised ESG and impact tools, the framework incorporates an independent impact team, a governance structure, and standardised ESG and impact tools, adds Verchere. “BlueOrchard has developed a comprehensive methodology that enables regular review and attribution of impact to the financing provided by the Fund, accounting for differences between labelled and general-purpose bonds”, he explains. “Our robust impact calculation methodology gathers standardised impact indicators at the bond level for labelled bonds and at the issuer level for general and sustainability-linked bonds. Allocations based on the investment level and bond value, or enterprise value, are then summed at the portfolio level to determine overall fund-level impact indicators.” The B.Impact platform has been externally verified by independent provider BlueMark, achieving the highest ratings across the board.
The focus on emerging markets is a fundamental component of the investment strategies of both funds. Does this inevitably lead to a greater variety of risks? For Verchere, the perception of risk levels in emerging markets may stem slightly outdated viewpoints: “Emerging markets are often perceived as riskier than their developed market counterparts due to their political and institutional risks. However, over the past two decades, these markets have significantly improved, and a crisis in one country no longer has a detrimental effect on the entire region. Such events are now more idiosyncratic, meaning they can be diversified while still collecting the risk premium. Although institutional risk has also improved significantly relative to developed markets, it remains quite disparate.” In Verchere’s experience, emerging market corporates have been enhancing their financials considerably and can arguably be considered better prepared for hardship.
There must nevertheless be instances where emerging market portfolio managers must swiftly react to macroeconomic or political instability in certain corners of their diverse investable universe. Verchere concurs: “The current political situation in Romania is a good example. Valuations are particularly attractive, as there is a risk of downgrade due to political instability and the fiscal situation. However, investors are receiving a risk premium for something that is uncorrelated to today’s main risk factor: the trade war. The fact that it represents idiosyncratic risk means that it can be diversified, which can increase the risk-adjusted return. However, it needs to be sized nimbly to avoid an adverse impact on the fund’s performance. On the macro side, as it became increasingly obvious that inflation was not transitory, our ability to hedge part of our interest rate exposure significantly benefited us in 2022 and 2023.”
Institutional asset owners represent a vast potential market for new strategies as they seek to add impact across all asset classes in their portfolio. How does Verchere view the growth potential of fixed income impact products, and will the US-driven ESG backlash represent a strong headwind for progress? He believes the nature rather than the sheer number of issuers will be the best measure of success: “While initially green bonds were predominantly issued by high-quality government bodies, we can now find a diverse array of issuers from various regions and ratings. This allows portfolio managers like us to build portfolios with different levels of risk and return. Although the ESG backlash is impacting on the US market, Europe and emerging markets remain relatively resilient. Additionally, to ensure sustainability in the long run, ESG or impact investments should not rely on government subsidies. Therefore, the backlash should reinforce the selection of viable business models.”
Another pillar for growth is the spread of blended finance, which Verchere considers crucial for enabling private capital mobilisation in emerging markets, especially in the context of private asset investments. “We see this tool being increasingly used by several market players. Blended finance requires scale; therefore, at BlueOrchard, we are exploring innovative ways of blending. One such approach is to offer private investors investment-grade notes that can easily fit their asset allocation. This instrument seems particularly relevant for insurers who need long-term assets to match their liabilities.” Verchere does acknowledge that the US political climate is impacting budget allocations for development finance institutions (DFIs) and multilateral development banks (MDBs), with some institutions in a “wait and see” mode. He nevertheless retains a positive outlook: “We expect this to be temporary, and in the meantime, we are focusing our efforts on collaborating with those institutions that remain very active to maintain momentum.”
