Green Parity and the Decarbonization of Corporate Bond Portfolios

Abstract

This study explores the incorporation of climate change into fixed income investment. We investigate the cost of decarbonization and the selection of Sustainable Investment strategies in portfolio construction, providing a comprehensive analytical framework. Employing a passive management style and through empirical analysis, we assess the tradeoff between decarbonization and the associated cost in terms of benchmark deviation for a corporate bond portfolio. We also propose an innovative strategy called “Green Parity,” which helps to improve traditional approaches to decarbonization. Our results challenge the common belief that pursuing decarbonization targets inevitably compromises risk-return outcomes.

Keywords:

• carbon footprint
• climate risk
• corporate bonds
• decarbonization
• fixed income investment
• Green Parity strategy
• portfolio management
• sustainable investment

PL Credits:

• 2.0

Acknowledgements

The authors thank William Goetzmann (Executive Editor), Daniel Giamouridis (Co-Editor), and two anonymous referees for helpful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s). The opinions and analyses in this study are the responsiblity of the authors and not necessarily reflect those of the Banco de España or the Eurosystem.

Notes

1 The financial sector is excluded from the benchmark portfolio due to its high weight in the index (43.9%) together with its low scope 3 figures reported, which would bias the analysis.

2 Final Report EU Technical Expert Group on Sustainable Finance (2019a, 2019b). Recommendations of the Task Force on Climate-Related Financial Disclosures, pp. 36-37, GHG Emissions Associated with Investments: "… the Task Force has replaced the GHG emissions associated with investments metric in the supplemental guidance for asset owners and asset managers with a weighted average carbon intensity metric. The Task Force believes the weighted average carbon intensity metric, which measures exposure to carbon-intensive companies, addresses many of the concerns raised."

3 As is standard practice in environmental analysis, carbon emissions are used as a proxy for the different GHG emissions, which include, in addition to water vapor (H₂O) and carbon dioxide (CO₂), mainly methane (CH₄), nitrous oxide (N₂O), and ozone (O₃).

4 For simplicity, the latest available carbon intensity figure is used, acknowledging that this is a static metric and does not take into account issuers’ “climate ambition," i.e., their efforts to reduce their emissions footprint over time. Future analysis could be enriched by introducing dynamic intensity metrics, incorporating both past achievements on the decarbonization trajectory and future emission reduction plans by companies.

5 The maturity is constant over five years, the duration fluctuates weekly following changes in the IRR, but always yields values very close to 5.

6 For bullet bonds without optionality, the periodic return calculation is practically the same whether taking clean prices plus accrued coupon or approximating it by a second-degree Taylor expansion as applied in this paper (Bajo and Rodríguez 2013). The main difference is that in the second case the duration of the portfolio can be kept constant over time.

7 By mentioning this relationship between the issuer's WACI reduction and its bonds’ volatility, we point to a mere casual, rather than causal, correlation. The analysis of the relationship between the temporal dynamics of an issuer's carbon footprint and the return-volatility properties of its securities is beyond the scope of this study.

8 The GICS sector and industry classification has been used for the individual issuers.

9 See the final report of the EU Technical Expert Group on Sustainable Finance (TEG). For simplicity, only the initial 30% and 50% reduction in carbon footprint against the baseline portfolio is illustrated. EU standards also dictate an additional decarbonization trajectory of 7% on average per year, along with other exclusion requirements for certain activities and companies.

10 Short selling in the corporate bond market can be implemented through the use of credit derivatives (like CDS) or by borrowing the security in the repo market to sell it outright. The borrowing involved may include the use of leverage, and if the price of the bond increases instead of falling, the investor might suffer large losses.

11 Other SI strategies are increasingly being applied in the fixed income world, such as (i) thematic or impact investing, which seeks to actively direct investment towards an explicit environmental impact objective, for example, by constructing a green bond portfolio; (ii) engagement, which uses the investor’s influence to try to steer the issuer's SI factors and risk exposure and/or increase its transparency to the market on these aspects; and (iii) integration, which attempts to holistically incorporate extra-financial information and SI considerations, both qualitatively and quantitatively, into the investment process and management decisions.

12 The tangent hyperbolic function (tanh) is an activation function used in neural networks with the aim of introducing non-linearity into the network, thus allowing the learning of more complex patterns.

13 However, the nature of the climate risk metric (${\mathcal{C}\mathcal{I}}_i$) differs from volatility, as the latter satisfies the sub-additive property [σ(x) ≤ ∑x_iσ_i] due to correlation, while climate risk does not provide diversification gains.

Additional information

Notes on contributors

Mario Bajo

Mario Bajo is Head of Risk Measurement Unit at Banco de España and co-director of the Active Fixed Income Management programme at Instituto BME, Madrid, Spain. Emilio Rodríguez is Head of Asset Management Division at Banco de España and co-director of the Fixed Income Active Management programme at Instituto BME, Madrid, Spain.

Emilio Rodríguez

Mario Bajo is Head of Risk Measurement Unit at Banco de España and co-director of the Active Fixed Income Management programme at Instituto BME, Madrid, Spain. Emilio Rodríguez is Head of Asset Management Division at Banco de España and co-director of the Fixed Income Active Management programme at Instituto BME, Madrid, Spain.