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Climate transition puts high-yield bond investors at risk

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Investors in high-yield bonds may be more exposed to the risk of a climate transition than those in other debt and equity assets, according to new research from MSCI. 

Many investors are looking further down the ratings ladder because of the low-yield environment in fixed income, and the high valuations commanded by debt issuances marked as ‘green’ or ‘sustainable’.

The research team at MSCI looked at the risk to US corporate bond and equity benchmarks if policies were put in place to limit the increase in global temperature to 1.5 degrees by the year 2100.

It found that high-yield bonds have a higher exposure to risks from a climate transition than other assets, including investment-grade fixed income and equities.

High-yield corporate bonds had a downside repricing risk of -12.7 per cent, according to MSCI’s Climate Value-at-Risk (Climate VaR) model.

Meanwhile, the equity benchmark had a Climate VaR of -5.9 per cent, and the investment grade-corporate-bond benchmark showed the lowest level of transition risk, at -3.4 per cent.

“Institutional investors are increasingly focused on building greener portfolios, with reduced exposure to climate transition risk,” writes the team at MSCI. 

“Some might expect bonds to be less exposed to this risk as compared to equities, due to the seniority afforded to bonds by the capital structure. Yet that logic doesn’t necessarily hold at the portfolio level.”

Equity securities were initially expected to be most at risk, as these assets are the first to be impacted by the downside risk of climate transition, after which bonds get impacted. 

The gap between equities and bond benchmarks’ exposure to climate transition risks was driven by differences in the sectors that make up the indices, says MSCI.

The high-yield benchmark, MSCI USD High Yield Corporate Bond Index, has over a quarter of its market value in energy, materials and utilities companies — three sectors traditionally associated with high climate transition risk. 

Energy alone represents 14 per cent of the high-yield benchmark’s market value, and drives nearly half of the benchmark’s transition risk.

Meanwhile, MSCI’s US Investable Market equity benchmark is weighted towards the information technology sector, which makes up a quarter of the benchmark’s value.

“Our model-based analysis showed that the US high-yield benchmark had significantly greater exposure to climate transition risk than US equity or investment-grade corporate-bond benchmarks,” the research team concludes.

High-yield fixed income has become an increasingly enticing asset class to investors seeking to avoid the high valuations and low yields commanded by companies higher up the ratings ladder. 

Investors in high-yield bonds may be able to minimise the risks of a climate transition by “surgically removing” riskier sectors from their portfolios. MSCI constructed model high-yield portfolios with reduced risks at -1.7 per cent and -0.4 per cent.

“Our results also show that it might be possible to build greener high-yield portfolios without deviating too far from the benchmark’s risk characteristics, by surgically removing the exposures to issuers in sectors (such as energy, materials and utilities) with high climate-transition risk,” writes MSCI.

Meanwhile, investors are also showing a strong appetite for high-yield bonds that incorporate ESG characteristics.

In March, Greece’s main power utility firm Public Power Corporation raised EUR650 million in the first sustainability-linked junk bond issue in Europe. Strong demand from investors led the group to increase the size of the package by EUR150 million.

The bond’s ‘sustainability’ relied on the firm’s plans to cut carbon emissions by 40 per cent by the end of 2022. If the company fails to meet its target, bondholders will be paid an extra 0.5 percentage points more than the coupon.

European high-yield bankers are reporting that ESG-linked transactions in Europe typically raise a book of demand between 30 and 40 per cent larger than their non-sustainable counterparts, according to a recent insight from S&P Global Market Intelligence.

“This dynamic is driven by larger orders from investors rather than a higher number of orders, sources note, as buyside accounts can place bonds with a sustainable element into a larger number of their own funds, specifically green or ESG funds,” write S&P’s researchers.

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