“A substantial gap remains between current policies and required action; the world is yet to see the scale or speed of implementation needed to meet 1.5ºC targets. However, even on the current trajectory, significant spending is set to occur, the majority of which will come from debt markets,” says Freedman.
“Whichever way you look at it,” he continues, “a huge amount of additional capital needs to be funded, and refinanced over time, and global debt to gross domestic product will increase.” Fixed income already plays a major part in the re-engineering of the financial system and the role it has to play in funding the transition is becoming increasingly important.
Embracing labels
Major stimulus programs are already in place, but they are just the beginning. Sustainable finance is still relatively small but has been growing quickly. Indeed, fixed-income investors are now better able to direct capital towards improving outcomes.
“Some are through ‘labelled’ bonds, where proceeds are directed to specific projects or where a failure to meet certain targets results in the penalty of higher interest costs,” says Freedman, “but a growing appreciation of ESG (environmental, social and governance) analysis means standard (or ‘vanilla’) bonds, which make up by far the largest part of the bond market today, are an important tool too.” The labelled bond market, although US$2.0 trillion in size, represents a mere 2.9% of the global bond market.2
A fundamental focus
While investors need to be vigilant against the threat of greenwashing,3 demand for ‘labelled’ bonds is likely to continue to grow. “Fundamental analysis of ESG factors from a holistic perspective, rather than a single asset and project focus, can help investors avoid these pitfalls,” he explains.
The issue of fundamental analysis is a key one; there has been something of an anti-ESG movement in the US, centered on concerns that there isn’t enough focus on the financial performance of ESG investments. “But from a fixed income investor’s perspective,” Freedman argues, “important to credit is analyzing risk, growth and efficiency, all of which can be tracked and linked to ESG – it is a core tenet of what we do.”
A ‘just’ transition
It is increasingly important to consider the ‘just transition’; there are social consequences to funding with a climate focus. “In our opinion, green targets should not be considered in isolation; economic development objectives are also important,” he says.
Freedman continues, “To deliver meaningful change, we need greater accountability from all stakeholders, including governments, companies, investors, and asset owners.” Indeed, some environmental and other covenants have been introduced into debt securities, resulting in penalties for missing targets, for example, in sustainability-linked bonds.
“Some management teams we speak to admit that they have gone down the labelled bond route to benefit from the ‘halo effect’ and enjoy a lower cost of funding,” he warns. “In our opinion, broader and more robust accountability measures are key, as is more emphasis on the differences in the cost of capital between issuers.”
A powerful voice
As regulations expand, there will inevitably be more stranded assets and risks to business models. Sectors increasingly viewed as ‘dirty’, or challenged, will face higher risks, lower credit ratings and steeper yield curves. “This has material implications for fixed-income returns as credit risk for these issuers will increase, limiting the issuers’ access to capital at attractive interest rates,” argues Freedman. While bondholders can’t vote, they can engage, and can deny capital to issuers; what’s more, debt needs to be refinanced over time.
“It is also important to remember, however, that providing capital to those ‘dirtier’ sectors will enable them to transition,” he warns. “This is where engagement over exclusion is key; transitioning these sectors will result in huge wins for the planet and society, while at the same time, helping to keep costs down.”
“What we are certain of is that fixed-income investors will play a pivotal role in directing capital to projects that can help shift the dial to a potentially more equitable, lower-carbon way of life,” Freedman concludes.
