Weathered for Climate Risk: A Bond Investment Proposition

With scientific evidence regarding the contribution of carbon emissions to global warming mounting, pressure is building for corrective policy actions. The potential for such policies poses a risk for invested capital. We describe how bond investors using traditional portfolio construction techniques can hedge portfolios against this climate risk without introducing unintended exposures that could sacrifice the portfolio's benchmark tracking properties. We hypothesize how a pickup in low carbon investing may send out a pricing signal and preempt the connoted price correction. In that event, the transition toward a world economy with a sustainable level of carbon pollution would be accelerated, which would be beneficial for both the low carbon investor and the environment. The summary was prepared by Sandra Krueger, CFA. What's Inside? Government policies relating to climate change may affect the value of carbon intensive issuers, such as utilities and energy companies. Research by Andersson, Bolton, and Samama (Financial Analysts Journal 2016) on equity markets suggests that at the end of 2014, climate change risk was probably not fully priced yet. But credit rating agencies, such as Standard Poor's and Moody's, are expressing concern, and general awareness is growing. The authors extend climate risk research into fixed income portfolio management and use traditional portfolio construction techniques that "decarbonise" corporate bond portfolios by reducing the portfolio's exposure to carbon intensive issuers.  With interest rates currently at such a low level, capital preservation is a priority for investors. It is difficult to forecast the extent or duration of the effect that potential government climate policies may have on financial markets. But if, as the authors claim, the carbon footprint of a fixed income portfolio can be lowered by 50% without sacrificing the portfolio's benchmark tracking properties, investment committees may consider implementing this type of strategy. Considering climate risk in the investment decision making process can create a win win situation in which investments are protected and industries are incentivized to reduce carbon emissions.  The authors construct two portfolios to track a corporate bond index: one regular index tracking portfolio and one low carbon portfolio. They gather data from January 2011 to December 2014 for the index constituents, such as monthly total returns, index weights, modified durations, credit spreads, countries, and sectors, as well as carbon intensity scores. The screening process to build the low carbon portfolio begins by selecting bonds with the highest duration times spread (DTS) and/or highest weight in the index. Next, the authors run an algorithm that iteratively examines pairwise combinations of bonds within a stratified sector, making adjustments in their relative weights to improve the DTS match with their sector. Finally, bonds are screened and chosen based on their carbon saving score, which is the inverse of their carbon intensity score. Because there may be conflicts between the carbon reduction target and the DTS fit, the authors calibrate the test to uncover whether carbon intensity could be lowered by 50% or more without sacrificing tracking error volatility versus the index. The biggest reduction in carbon intensity came in the heavy industries, such as utilities and cement producers. The authors note that the most carbon intensive companies in the index are not necessarily excluded from the low carbon index tracking portfolio because a company's market weight in the index is taken into consideration to minimize tracking risk. The authors provide tracking performance results for the regular index tracking portfolio and the low carbon portfolio. They show that the low carbon portfolio reduces carbon intensity between 55% and 65% but it produces almost the same tracking error as the regular index tracking portfolio. Abstractor's Viewpoint Climate policy changes have been shown to reduce portfolio returns. After the carbon tax was enacted in Australia in 2011, the stock prices of some major carbon emitters dropped by around 6% Such headlines as "Billions Wiped from Blue Chips as Carbon Tax Hits Australia" and voter displeasure led to negative perceptions and the eventual repeal of the carbon tax. This research offers a potential solution to fixed income investors who need to manage downside climate risk. Although three years of data are not enough to draw any conclusions, the authors describe a methodology to partially eliminate carbon risk while maintaining a target tracking error. It is useful reading for asset managers who generally benchmark their fixed income portfolios but seek protection from this complex risk.  The authors' firm may have a commercial interest in the topics discussed in this article.  This article was reviewed and accepted by Executive Editor Stephen J. Brown. Authors' note: The views expressed in this article are those of the authors and do not necessarily reflect those of Amundi.