Climate-Focused Bonds: Seeking Ways to Weather Investment Risk | Lord Abbett
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Fixed-Income Insights

Here are the ways that a multi-sector investment approach can potentially help investors in this ESG category mitigate interest-rate risk and other possible headwinds.

Read time: 7 minutes

Key Points

  • The ESG-related fixed income market has continued to enjoy robust growth in recent years, paced by strength in labelled green bonds.
  • Green bond issuance is currently dominated by securities with higher quality and longer duration.
  • Investors seeking to combine support for climate stewardship with an attractive and diversified risk profile may be better served by embracing a multi-sector approach.

In a recent Market View, Lord Abbett Fixed Income Portfolio Managers Leah Traub and Annika Lombardi highlighted the impressive growth in global ESG bond issuance in 2020.  (As a reminder, ESG refers to environmental, social, and governance investment criteria.) They noted that 2020 was another record year for ESG-labelled bond supply, with nearly US$500 billion of debt issued, based on data from Morgan Stanley.  Indeed, ESG-labelled debt has become a significant pool of assets, with a recent report from Morgan Stanley putting the total amount outstanding at approximately US$1.3 trillion—rivalling the size of the U.S. high yield market. 1

Green bonds—those for which the proceeds are used exclusively to fund new and existing projects with intended environmental benefits—are a significant part of this market.    While there is no legal definition of what constitutes a green bond, the International Capital Markets Association (ICMA) has established widely accepted “Green Bond Principles.”  These principles outline acceptable uses of proceeds (eligibility of projects; ongoing management transparency and tracking of proceeds; and ongoing reporting) and provide the foundation for the methodology for various independent green bond certification schemes.  Green bonds are pari passu, or of an equal status, with conventional bonds from the same issuer.

Primary issuance in the certified or “labelled” green bond market continued to be robust in 2020, with issuers bringing US$214 billion to market, just slightly less than in 2019.1  Historically, development banks and supranationals were the primary issuers of green bonds, along with European utilities seeking to diversify away from traditional energy sources.  (See Figure 1.)

 

Figure 1. Corporates Account for a Growing Share of Green Bond Market
Share of green bond market by issuer type, as of year-end


Source: ICE Data Indices, LLC. Based on the composition of the ICE BofA Green Bond Index. “Supranational” refers to multinational associations within the global finance or economic development spheres. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Growing investor awareness around climate-related issues, along with evolving government policy and regulation, especially in Europe, has supported green bond issuance. Corporate issuers have increasingly embraced the sector as well–2020 was a record year for corporate green bond issuance at US$128.6 billion, versus just US$16.5 billion in 2015, according to data from Barclays and Dealogic. Today, corporates now comprise a modest majority of green bonds outstanding.

Investors who wish to incorporate pollution reduction or support broader climate outcomes often focus on the labelled green bond market to help achieve their objectives.  But what do investors actually own when buying a broad exposure to green bonds?  One good illustration might be the ICE BofA Green Bond Index, an investment-grade benchmark which includes corporate credit and sovereign government, supranational and agency (SSA) bonds. The breadth and diversity of issuers has increased meaningfully in recent years (as reflected in Figure 1) and as of 31 Jan 2021, the index represented US$625 billion in labelled green bonds from over 300 corporate and government-related issuers—an elevenfold  increase in size since 2015 (see Figure 2). 

 

Figure 2. Labelled Green Bond Market Has Expanded Greatly in Recent Years

Market value of the ICE BofA Green Bond Index (billion US$; left axis) and number of issuers in index (right axis)

Source: Bloomberg and ICE Data Indices, LLC. Data as of 31 January 2021. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Further evidence of the evolution and maturation of the asset class in terms of diversification and investability is provided by data on the underlying composition of the index by issuer type, geography, currency and credit quality (see Figure 3).

 

Figure 3. Green Bonds: The Composition of a Diverse Global Asset Class

Percentage of market value as of 31 January 2021 for indicated categories

Source: Bloomberg and ICE Data Indices, LLC. Based on the ICE BofA Green Bond Index. Data as of 31 January 2021. SSA=Sovereigns, supranationals, and agencies. DM=Developed market. EM=Emerging market. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Like other full-duration high grade bond indices, the green bond index has seen its overall duration increase significantly and its yield decline in recent years. These trends are the result of constituent borrowers’ efforts to lock in for longer periods of time the very low borrowing costs afforded by the current monetary policy environment, and also reflect the long-term time horizon in which many green-bond proceeds are used.  In fact, given the underlying issuers in the index, at a high level the characteristics of the green bond market are not dissimilar to those present in broad global fixed income benchmarks, such as the Bloomberg Barclays Global Aggregate Bond Index (see Figure 4).  

 

Figure 4. Green Bond Index and Global Agg Share Key Characteristics
Data as of 31 January 2021

Source: Bloomberg Index Services Limited, ICE Data Indices, LLC, and Lord Abbett. Green bond index= ICE BofA Green Bond Index. Global Agg=Bloomberg Barclays Global Aggregate Bond Index.  Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Not unlike the dilemma global aggregate investors face, the very long duration and meager yields (see top portion of Figure 5) mean that there are significant risks to principal in a rising rate environment.  Figure 6 outlines the impact on return of hypothetical rate increases across the Index.

 

Figure 5. Green Bond Benchmark Features Low Yield, Elevated Duration
ICE BofA Green Bond Index: Duration and yield (%) for the years 2010–2020

Source: ICE Data Indices, LLC. Data as of January 29, 2021 (latest month-end). For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Figure 6. The Potential Implications of Elevated Duration During Periods of Rising Rates

Source: ICE Data Indices, LLC and Lord Abbett. Data as of January 29, 2021 (latest month-end). “Bps” refers to basis points; one basis point is one one-hundredth of a percentage point. The performance information above is hypothetical and there can be no guarantee that such returns would be realized. The hypothetical performance under various interest-rate increase scenarios is based on the duration formula that for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration. 
Past performance is not a reliable indicator or guarantee of future results. The data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Several years ago, Lord Abbett Investment Strategist Joseph Graham wrote “The Limits of Duration Risk: An Argument for Diversification in Fixed Income,” exploring the concentration of duration risk in the Bloomberg Barclays U.S. Aggregate Bond Index.  Because the general characteristics of the green bond market looks not dissimilar to those of an aggregate index, the analysis presented there is instructive in examining the underlying risks contributing to the variance in returns of the green bond market as measured by the ICE BofA Green Bond index (see Figure 7).

 

Figure 7. Sources of Variation in Returns for the ICE BofA Green Bond Index
Data as of 31 December 2020

Source: Bloomberg and Lord Abbett. Data as of 31 December 2020. Green bonds represented by the ICE BofA Green Bond Index (Hedged USD).
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Looking closely at the relative contribution of credit and curve risk to variance in index returns, (as of 31 December 2020) it’s fascinating to find that the vast majority of the projected variance in the returns (relative to cash) of the Green Bond Index is due to movements in the interest-rate curve, with other risks such as credit and idiosyncratic risks comprise a minor part of the return profile of the index.  For the purpose of understanding the impact of interest rates versus credit risks, we’ve hedged currency risk because volatility from currency movement displaces all other factors, and in today’s low yield environment investors in high grade fixed income frequently seek to hedge this risk out themselves.

ESG: A Broader Approach to Climate-Focused Investing

With interest rate risk as the dominant risk in the ICE BofA Green Bond Index (the "Green Bond Index") and considering the relatively poor trade-off between duration and income, we believe investors concerned with climate stewardship and other ESG considerations should broaden their considerations beyond off-the-shelf indices to generate attractive returns in a low yield environment.  In “Narrowing the Focus in ESG While Broadening the Opportunity,” Portfolio Manager Annika Lombardi, who co-manages the Lord Abbett Climate Focused Bond Fund outlines a more expansive approach to climate focused investing. Rather than taking as a given that a bond is ‘green’ simply because it is labelled as such, Lombardi argues that investors should embrace a more authentically integrated and principles-based approach. The result is a differentiated strategy that avoids a one-size fits all approach to investing in support of climate principles.

Incorporating our active, multi-sector approach to credit and fixed income investing, the Fund can express well-considered views on cross-sector relative value and opportunities for excess return both within the labelled green bond market and, at the issuer level, in credits whose activities are closely aligned with pivotal climatic themes but whose debt securities trade as “unlabelled” green bonds.  In the case of the former, the Fund can potentially take advantage of the enhanced yield opportunities provided by USD-denominated bonds today that simply aren’t available in the high grade EUR-denominated bonds that comprise about two-thirds of the Green Bond Index. Similarly, the Fund can potentially express a more nuanced view on duration, both on an absolute and relative basis, considering the yield curve profiles of the underlying currencies that comprise the index.

The challenge of low yields and long duration may also be mitigated partially by expanding the opportunity set to individual bonds that are not explicitly labelled as green bonds but where the underlying issuer or designated use of bond proceeds strongly align with one of the climate-oriented themes we have identified as representing investable structural changes in the economy driven by the global climate. For example, we consider investment in companies whose revenues are generated primarily through activities targeting a clean energy solution, but whose debt securities aren’t specifically labelled as green bonds.  Here, in order to ensure adherence to our requirement to invest in securities of issuers we believe have, or will have, a positive impact on the climate through their operations or the products and services they provide, we analyze (among other things) an issuer’s commitment to sustainability, the percentage of revenues and profitability it generates through pursuing climate positive themes and the issuer’s Scope 1 and Scope 2 emissions data.  These unlabelled green bonds often originate from sectors of the fixed income markets that are not represented in green bond indices. For example, many of these issuers are specialised sub-investment grade companies, or perhaps are younger technology companies that are more likely to issue in the convertible bond market than in traditional corporate debt markets. While these unlabelled green bonds may not have issued under the aegis of a formal green bond label, we believe they provide a demonstrable contribution to improving the climate and importantly enhance the risk and reward profile of the Climate Focused Bond Fund.

A Final Word

Investor focus on the impact of economic and corporate activity on the climate continues to increase and is being expressed organically through societal awareness, corporate initiative and government regulation and intervention. We believe the green bond market is an increasingly attractive avenue for governments and companies to secure funding for initiatives supporting climate-oriented objectives.  However, in aggregate this market is increasingly characterized by longer-dated, lower coupon bonds.  For investors who want to support climate-positive endeavours without undue or unintended exposure to interest rate duration, we believe a multi-sector approach to fixed income may provide a more attractive risk and reward profile.  At Lord Abbett, we believe our demonstrated success in multi-sector fixed income investing provides a robust foundation for investors seeking to invest in sustainability and to harness the potential benefits of active management through the assessment of relative value and the avoidance of unnecessary risks.

 

 

 

[1] Morgan Stanley Global Fixed Income & ESG Strategy, ESG Bond Quarterly Tracker, 06 January 2021.

 

New Fund Risk: The Fund is recently organized. There can be no assurance that the Fund will reach or maintain a sufficient asset size to effectively implement its investment strategy.

A Note about Risk: The Fund is subject to the general risks associated with investing in debt securities, including market, credit, liquidity, and interest rate risk. The value of your investment will change as interest rates fluctuate and in response to market movements. When interest rates fall, the prices of debt securities tend to rise, and when interest rates rise, the prices of debt securities are likely to decline. The Fund is subject to the risk that its climate-focused investment strategy may select or exclude securities of certain issuers for reasons other than investment performance considerations which may negatively affect its performance relative to unconstrained peers. Certain climate-focused investments may be dependent on government policies and subsidies, which are subject to change or elimination. The Fund may invest in high yield, lower-rated debt securities, sometimes called junk bonds and may involve greater risks than higher rated debt securities. These securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. The Fund may invest in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. The fund performance history at this time is very limited; therefore, performance achieved during its initial period of investment operation may not be replicated over longer periods and may not be indicative of how the Fund will perform in the future. These factors can affect Fund performance.

The Fund's portfolio is actively managed and is subject to change.

Important Information for Investors

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett Funds. This and other important information is contained in the Fund's summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at 888-522-2388 or visit us at lordabbett.com. Read the prospectus carefully before you invest.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The credit quality of the debt securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from `AAA' (highest) to `D' (lowest). Bonds rated `BBB' or above are considered investment grade. Credit ratings `BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially- conscious investors use to screen potential investments.

Green bonds: Labeled green bonds are bonds that earmark proceeds for climate and environmental projects. Labeled green bonds are often verified by a third party, which certifies that the bond will fund projects that include environmental benefits. Unlabeled green bonds (or climate-aligned bonds) are securities whose proceeds are supposed to be used for climate-aligned projects and initiatives but are issued without formal certifications.

Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in investing in a specific asset, as opposed to risk that affects the entire market or an entire investment portfolio. 

Pari-passu ("equal footing") describes situations where two or more securities are equally managed without preference and are treated the same under various circumstances.

Under greenhouse gas protocols defined by the World Resources Institute, Scope 1 emissions are direct emissions from company-owned and controlled resources. Scope 2 emissions are indirect emissions from the generation of purchased energy from a utility provider. Scope 3 emissions are all indirect emissions (not included in Scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).

swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.

The Bloomberg Barclays Global Aggregate Bond Index is a broad-based measure of the global investment-grade, fixed-income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate indexes. The index also includes euro dollar and euro/yen corporate bonds, Canadian government securities, and U.S. dollar investment-grade 144A securities.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The ICE BofA Green Bond Index tracks securities issued for qualified green purposes that promote climate change mitigation or adaption. Qualifying bonds must have a clearly designated use of proceeds that is solely applied toward projects or activities that promote climate change mitigation or adaptation or other environmental sustainability purposes as outlined by the ICMA Green Bond Principles.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Copyright © 2021 Lord, Abbett & Co. LLC. All Rights Reserved.   Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC.

 

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