For some investors, sustainable investing necessitates reducing portfolio emissions. Adding this new set of targets to the investment objectives — i.e., emission-reduction targets — requires a careful navigation of market complexities and risk considerations alongside sustainability metrics and objectives. A “climate glidepath” may help by mapping out a plan and keeping investors on course.
In our previous paper, Net-Zero Glidepaths for Fixed-Income Portfolios, we showed how bondholders could devise portfolios to meet emission-reduction goals while aligning with their core security-selection processes and financial-mandate constraints.[1]
In this blog post, we used the framework to simulate portfolios for index-tracking and buy-and-hold investors in USD investment-grade (IG) corporate bonds issued by companies from the Global Industry Classification Standard (GICS®) energy sector.[2] All portfolios were backtested from September 2019 to December 2023, with monthly rebalancing.[3] At each rebalancing, portfolio turnover was restricted to reinvesting cash generated by the portfolio.[4] The climate glidepath shaped the portfolio-construction approach by integrating decarbonization as a constraint in the security-selection process over time. This approach entails establishing emission constraints relative to the baseline levels of the initial portfolio as of the fourth quarter of 2019.[5]
Climate glidepaths for index-tracking investors
Index-tracking investors represent a significant cohort among corporate bondholders. These investors generally aim to deliver returns close to their broad-market peer (indexed strategies) or some premium (active or total-return funds). We simulated two climate glidepaths, both controlling for active risk versus the USD IG energy market.[6] The portfolios adhered to constraints on credit-bucket allocation and sub-industry and issuer concentration.[7] One aimed to minimize active risk while reducing emissions by 3.5% annually (relative to the levels as of September 2019).[8] The other prioritized minimizing emissions while managing for active risk.
During the analysis period, market emissions remained elevated compared to September 2019. Even so, the climate glidepaths continued to trend toward decarbonization. The degree of decarbonization achieved was significantly impacted by the active risk, however. While the first glidepath simulation kept active risk below 35 basis points (bps), this approach failed in reducing emissions during periods of market-emissions increases or when cash flows were limited.
By experimenting with different levels of active risk for the second glidepath setting, we found that to closely adhere to their decarbonization objectives, investors would have needed to allow for at least 70 to 80 bps of active risk. In this setting, the portfolio maintained its decarbonization objectives at the expense of a difference between the portfolio's effective duration and the market. This setup provides an example of flexibilities required to maintain both climate and financial objectives of the portfolio while the decarbonization of the portfolio is slow due to natural speed of change in this high-emitting sector.
How index-tracking climate glidepaths reduced portfolio emissions
The outperformance of the climate glidepaths compared to the market primarily stemmed from differences in sub-industry allocation, particularly the underweighting of integrated oil and gas, a sub-industry with high average emissions that underperformed throughout most of the analysis period.
Climate glidepaths for buy-and-hold investors
Buy-and-hold corporate-bond investors may have liability-driven mandates — e.g., insurers and defined-benefit pension funds. We simulated three hypothetical energy portfolios, each invested in five sub-industries representing over 95% of the USD IG energy sector.[9] All simulated portfolios adhered to the same financial constraints.[10] The base buy-and-hold portfolio had no decarbonization constraint, while the two glidepath portfolios aimed to reduce their carbon emissions by 3.5% annually, relative to the levels of September 2019. Additionally, the second glidepath portfolio allowed sales of bonds up to 1% of the portfolio market value.
Our analysis demonstrated that the glidepath portfolios were able to meet the expected emission-reduction targets over the backtested period. In instances where cash flows and reinvestment were insufficient to reduce portfolio emissions adequately, the glidepath portfolio without sales carried forward the emission-reduction budget to the next rebalance. However, permitting the small 1% sale enabled the second glidepath portfolio to achieve the targeted emissions reduction across nearly all rebalance dates.
How buy-and-hold climate glidepaths reduced portfolio emissions
Both glidepath portfolios maintained compliance with required financial constraints (i.e., duration target, credit allocations and issuer and sub-industry concentrations). Yield differences relative to the base portfolio were low; the differences in excess returns may be primarily attributed to the underweight of companies from integrated oil and gas in the glidepath simulations.
Climate-glidepath solutions could help in attaining impact-investment goals
Climate glidepaths solutions could provide useful tools to help investors align their investment objectives with their impact goals of decarbonization of their high-emitting portfolios, especially energy-sector portfolios. However, the success of a climate-glidepath approach relies on the assumption that enough companies and issuers will reduce their emissions with the aim of reducing economy-wide emissions to net-zero. If the emissions of issuers in the investable universe are not adequately reduced, it is likely, as in our analysis, that the portfolio will diverge over time from the investment objectives.
Decarbonization entails costs and may pose challenges within existing financial frameworks. When faced with such scenarios, investors are compelled to make strategic decisions, whether they involve adjusting decarbonization rates, allowing divergence from market neutrality (i.e., different duration targets or sector/industry allocation), reconsidering positions (potentially through sales) or permitting portfolio shifts away from other aspects of their investment mandates).
The authors would like to thank Ray Wang and Akhil Kappagantula for their contributions to this blog post.