Dirty debt: rising yields put spotlight on carbon footprint of bond portfolios

Bonds have made a comeback in 2023, a trend that is widely anticipated to last into 2024. With yields on long-dated government debt and AAA+ rated corporate debt now offering returns around 4-5%, institutional investors are rediscovering their love for fixed income assets.

More than 70% of institutional investors said that they believed rising rates combined with a gradual decline in inflation would lead to a resurgence in fixed income investments, according to an asset allocation survey conducted by Natixis in 2023.

But this raises the question of how investors are planning to tackle the carbon footprint of their fixed income portfolios.

Climate campaigners draw attention to the fact that the the coal industry receives the bulk if its funding from bond issuance rather than lending. Moreover, approximately half of all fossil fuel financing derives from corporate bond issuance, according to research by Client Earth and Make My Money Matter.

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Research by Make My Money Matter estimates that UK pension funds hold at least £88bn of investments in the fossil fuel industry, of which approximately a quarter in fixed income assets.

Targeting UK institutional investors in particular, Client Earth has sent a letter to the 12 largest pension funds in the UK, urging them to cease lending to the fossil fuel industry unless the companies in question have developed credible transition plans.

Client Earth said the letter has been sent to USS, the Electricity Pensions Trustees Limited, BT Pension Scheme, the Natwest Pension Scheme, Railpen, the Lloyds Pension Scheme, the Barclays and BAE Systems pension funds, Coal Pensions Superannuation, HSBC, BP and British Airways. Schemes were selected for being the largest in terms of assets (excluding the LGPS) rather than based on their climate strategies. 

While pension funds have stepped up their engagement efforts in equities, there appears to have been little effort to tackle their carbon footprints in fixed income assets. This could represent a breach of their fiduciary duties, according to Catriona Glascott, a lawyer at Client Earth.

“Fossil fuel projects have a high chance of being rendered obsolete in coming decades as the world’s energy system transitions to renewables. Pension beneficiaries are having their funds thrown behind risky projects for potential short-term profits – a strategy that risks undermining long-term reward for customers,” she said.

In the UK, pension funds in excess of £1bn in assets are now required to file annual TCFD reports and at least one scheme has already been fined by The Pensions Regulator for failing to release its report in time.

Put clause

ClientEarth suggests that in order to step up their stewardship game, lenders could include a put clause into new deals, which would require issuers to repay their debt early if they failed to stick to their transition strategies.

However, with many institutional investors keeping bonds on a buy and hold basis, it could take years if not decades for such clauses to be widely applied.

“Pension schemes – which promise a secure future in principle – have the chance to make that both a planetary and material reality for beneficiaries. They can make bond financing dependent on climate commitments and ensure that credible company transition plans are a condition for investment,” Glascott argued.

Investors have made attempts to address these challenges. For example, the Institutional Investor Group on Climate Change launched new guidance on bond holder stewardship in corporate bonds last year.

Chandra Gopinathan, a senior investment manager in Sustainable Ownership team at UK defined benefit fund Railpen, has been actively involved in drafting the new guidance. He argued that an important starting point could be greater transparency in fixed income assets.

“What we are trying to do is start the discussion around prospectus disclosures and indenture disclosures around climate and net zero considerations. If the issuer has climate considerations and net zero plans, there is no reason why they couldn’t disclose that as part of their prospectus. What is your emissions footprint, what is your target? That way investors can do an alignment assessment and see if the bond is actually aligned to the issuers transition plan or not,” he told Net Zero Investor.

Also read:

Chandra Gopinathan on bondholder stewardship: we have to create new accountability mechanisms