Corporate bond managers urged to explain climate transition risks

Dan Mikulskis, partner at LCP, tells Mandate Wire that corporate bonds, which are currently around the third-largest asset allocation for UK private sector DB pension schemes, are expected to become the core holding in the future.

However, climate-aware investors must consider how the transition to a low-carbon economy will affect their corporate bond holdings, especially the “buy and maintain” portfolios, Mikulskis notes.

Corporate bonds tend to be more exposed to sectors that will be subject to transition risk than similar equity benchmarks.

While a bond investor does not have the same voting rights as equity investors, as many firms frequently come back to the market, it is possible to change corporate behaviour during these financing rounds

Dan Mikulskis, LCP

“Utilities could be up to 15 per cent to 20 per cent of [bond] portfolios, and there is also a considerable exposure to both industrials and real estate,” he says.

Range of approaches

Within each of these sectors, companies have a range of approaches to climate change.

“For example, Eon is forward thinking about its transition to a greener future, while some Japanese power companies are much further behind,” Mikulskis notes, pointing out that these factors are often not priced into the bond portfolio.

It is now much easier to analyse the different transition risks for companies because of the development of strong independent assessments of these hazards. Investors can take advantage of, for example, science-based targets and the transition pathway initiatives.

Mikulskis argues a more detailed analysis of companies’ attitude to transition risk can enable institutional investors to assess which companies they want to be represented in their corporate bond portfolios.

“This allows institutional investors to put forward guidelines for asset managers, which will make them think about the climate alignment with the emission intensity of those companies,” he says.

Net-zero targets

Some institutions might select companies with better climate alignment for their corporate bonds portfolio. Others will choose companies that they can engage with to improve their transition plan.

Mikulskis says: “While a bond investor does not have the same voting rights as equity investors, as many firms frequently come back to the market, it is possible to change corporate behaviour during these financing rounds.”

Equity investors can use their voting rights to engage, but he notes that these investors will effectively deny debt financing to those companies that are not aligned with the goal to achieve net-zero carbon by 2050.

It would be unrealistic, however, to expect companies to know exactly how to achieve the net-zero goal today. Mikulskis says investors are looking for the target to be acknowledged and for management to be thinking strategically about how they can reach net zero.

At the moment, few investors are assessing transition risks and they are not being accurately reflected in the corporate bond market. “I find it hard to understand how investors are being fairly compensated for transition risks when all corporate bond spreads are so low,” he argues.

Acknowledge shortcomings

With investment consultants starting to focus on climate-related issues for their institutional clients, it will become important for asset managers to build these risk assessments into their portfolio construction.

Mikulskis has noticed a growing number of corporate bond managers assessing transition risk during the past year. Some managers are building proprietary models, while others are using external data sources.

Rather than focus on carbon emissions alone, managers are increasingly looking at how companies are planning to align with net-zero carbon goals.

Mikulskis urges asset managers to communicate their process to institutional clients and be honest about the shortcomings of some of the models. They must also be transparent about how their risk assessment works.

“While the analysis on climate risk in some companies is very advanced, it is less clear how these translate into practical steps for the managers to take when they are designing and monitoring their portfolios,” he says.

Mikulskis notes that institutional investors are often looking for simple ways to get a handle on the transition risk in the whole portfolio. “Sometimes we find that some very straightforward frameworks, which are much less sophisticated than those used by the managers, are really helpful for pensions schemes,” he says.

He advises asset managers to keep these simple frameworks in mind when they communicate with the asset owner.

This article originally appeared on MandateWire.com