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Transitioning fixed-income portfolios to low-carbon assets
Active management to help diversify risks and enhance sustainable returns
1 Mar 2021 | Bayani S. Cruz

Asian asset owners, particularly pension funds and insurance companies, are in danger of losing massive amounts of the value of their assets unless they can transition their fixed-income portfolios to low-carbon assets on time to meet the targets set in the Paris climate agreement.

Since fixed-income assets make up the bulk of their portfolios, these institutions must be able to transition their portfolios to achieve the target of limiting global warming to well below 2 degrees Celsius, preferably to 15°C, compared to pre-industrial levels, by 2050.

This means asset owners have to actively manage (versus passively managing) their fixed-income portfolios and navigate the impact of climate-driven technology and policy changes on portfolio performance in line with the recovery in global economic activity post-pandemic, according to a white paper, “Building carbon transition fixed income portfolios”, published by J.P. Morgan Asset Management (JPMAM) in February 2021.

The challenge that faces asset owners, particularly insurance companies, is that their portfolios are heavily invested in sovereign bonds which are highly exposed to high-carbon industries.

This has material consequences for passively managed fixed-income portfolios, the traditional go-to investment strategy for pension funds and insurance companies. Insurers’ fixed-income portfolios, in particular, have sovereign bond holdings that are most exposed to high-carbon industries and could suffer a decline in value of up to 4%, according to JPMAM.

Corporate bond portfolios will also feel the impact of climate change policies because the introduction of emissions trading schemes, or outright carbon taxes, are likely to expose costs previously unaccounted for in an issuer’s balance sheet and cash flow expectations which could have material impacts on credit fundamentals and ratings.

In determining the carbon transition goals of an issuer, JPMAM looks at its bond covenants using a bond-by-bond selection process which allows it (JPMAM) to go beyond an issuer’s carbon intensity and also take into account specific features that are embedded in the bond covenants. This can help asset owners achieve carbon transition goals.

Portfolio construction

JPMAM considers three types of securities in its carbon-transition portfolio construction process, namely green bonds, sustainability-linked bonds, and transition bonds.

In the case of green bonds, the proceeds are aimed at financing specific carbon-reduction projects, while benefiting from the creditworthiness of the issuer’s entire balance sheet.

Sustainability-linked bonds are issued for general corporate purposes, hence, they lack the environmental specificity of green bonds. On the other hand, they feature environmental goals in their covenant structure.

Transition bonds are an emerging type of financing used in sectors that are hard to decarbonize (e.g., mining, steel, cement, and shipping). Transition bonds aim to fund investments that have yet to reach low or zero emissions but have a short-term role to play in decarbonizing an activity or supporting an issuer in its transition to net-zero targets.

From a technology standpoint, the growing importance of renewables will cause more assets to become stranded from old intellectual property, such as combustion engine patents, to physical property including coal power plants and energy-inefficient real estate.

This can also be an important driver of value in actively managed portfolios, where asset-heavy fixed-income sectors such as utilities, energy, automotive and basic industry represent a large proportion of corporate bond indices.

“Integrating carbon transition into the investment process does not need to come at the expense of higher financial risks or lower returns. Future technological advancements and regulatory developments will require insurers and pension funds to become ‘carbon transition ready’ and this presents opportunities to diversify risk and enhance more sustainable profitability in the future,” Emily Homer, JPMAM vice president and fixed-income portfolio manager, says in the white paper.

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