For many pension funds in the UK, efforts to invest sustainably have typically started with equity portfolios. It’s changing; investors are building sustainability into their fixed income portfolios, harnessing the benefits of green, social and sustainable bonds. British pension funds must not be lacking.
Given the income generation and liability matching roles that bonds play within a portfolio, fixed income allocations are an important part of a pension fund’s balance sheet. We believe that durable bonds are an important part of the asset mix.
Green bonds are used to establish a credible path to net zero carbon emissions by funding ambitious green projects
Green bonds – we see green bonds as a subset of sustainable bonds – were first implemented in multi-asset portfolios. They are now used in liability-focused portfolios and beyond. Rising allocations among institutional investors fueled issuance, leading to rapid growth in the green bond market.
Policy initiatives in the UK and Europe have also played an important role in the growth of the market. In 2020, the EU rolled out a major social bond program, with a major green bond program scheduled for the end of the year; the Netherlands have issued their first green sovereign bond and the UK government is about to issue its first green gilt.
For governments and businesses, green bonds have become a tool to signal both intention and commitment to tackle climate change. Green bonds are used to establish a credible path to net zero carbon emissions funding ambitious green projects.
Sustainable bond market for typical LDI portfolios (approx. GBP 330 billion)
These are government bonds in EUR and GBP, bonds backed by government bonds (agencies, AA- or better) and supranational (AA- or better). The British show is expected in September.
But first, what is a green or sustainable bond?
Durable bonds are the same as conventional bonds in terms of financial characteristics: they have a fixed term, a fixed notional and a fixed coupon. The main difference is that the proceeds of sustainable bonds are used for green, social or sustainable purposes, such as a renewable energy project or social housing.
Okay, but how do we know the bond is lasting? How to avoid greenwashing?
Durable bonds are not a label. They must be underpinned by transparent and substantial green or social references. When investing in a durable bond, it is important to pre-check the terms of the durable bond product. This can increase costs both for the issuer in providing the information and for the investor in terms of monitoring, although it allows pension funds to understand the impact of their investments on sustainability.
For example, green bonds should help a company or a country to go carbon free. Pension funds should avoid green bonds which are used as a refinancing technique, where pre-existing “greener” activities are bundled under a green bond, but there is little change by the company as a whole. We need to make sure that green bonds are part of a meaningful transition plan.
At Cardano, we use the ICMA Green and Social Bond Principles, a set of voluntary guidelines that recommend transparency and disclosure and promote integrity in the development of the sustainable bond market. We also need a second party opinion from a reputable supplier.
Do sustainable bonds trade at a premium?
Investing in durable bonds is not a free game. Investors should assess and be comfortable with the premium, especially for investors who hold to maturity
Yes, durable bonds can be traded at a premium over their conventional counterpart. However, in our experience, the demand for durable bonds is growing faster than the supply. This puts pressure on prices. In the case of green bonds, this premium is called “greenium”: the difference in yield between a green bond and a comparable conventional bond.
We are more and more comfortable with the premium. First, we see it as a factor in the overall qualitative assessment of the investment. Second, as the supply increases, the demand increases faster, often causing the premium to increase, which benefits an active strategy.
But why would a pension fund invest in sustainable bonds?
Sustainable bonds offer an effective solution to pension funds looking to hedge the interest rate risk on all of their commitments while investing in a sustainable manner. Investing in green bonds (at least those with strong frameworks) ensures that the capital supports progress towards climate change goals. This is particularly relevant for UK pension funds given their approach to setting TCFD targets.
However, investing in sustainable bonds is not a piece of cake. Investors should assess and be comfortable with the premium, especially for investors who hold to maturity. Affordability and liquidity remain relatively low for buyers and there is no doubt that the sustainable bond market, at least for now, remains a seller’s market. And pension funds should be at the forefront in screening and due diligence to avoid greenwashing.
And after that ?
At Cardano, we have been investing in sustainable bonds for some time. We have a number of investments in sustainable bonds denominated in GBP and EUR, of which we appreciate both the investment logic and the environmental benefits. And there is room for our allocations to increase. The UK government has pledged to issue £ 15bn in green bonds this year, with the first tranche of around £ 7bn expected in September.
We believe durable bonds are here to stay. They are an important part of the asset mix and should be firmly on the agenda of UK directors.