Henrietta Pacquement and Wai Lee, Allspring Global Investments

Henrietta Pacquement and Wai Lee, Allspring Global Investments

Yields and Climate Risk Drive FI Allocations


As bond yields have increased and inflation has started to stabilise, targeted-return investors may reduce the risk in their portfolios by raising the level of fixed income relative to risky assets. This might be an especially prudent move now, as the unpredictability of climate change is likely to increase the level of volatility in markets going forward, Allspring Global Investments warns.

Looking back over the past 20 years, two key events stand out that changed the direction of investment markets.

The first one is the Global Financial Crisis (GFC) of 2008, which sparked a response from central banks that was unprecedented in both its magnitude and synchronicity. Cash rates were slashed all over the world — in some cases to the point where they dipped into negative territory.

In 2012, the central bank of Denmark became the first to explore this previously unknown territory of subzero rates, and it was joined by several European central banks two years later.

For institutional investors that target a specific rate of return, as many pension funds do, this posed an issue, as they were forced to take on more risk in order not to fall too far behind.

But the second key event changed all of this yet again. We are, of course, talking about the COVID-19 pandemic.

“The Global Financial Crisis pushed many central banks to get synchronised on easing, whereas of course COVID did the opposite; it pushed many of the central banks to get synchronised on tightening,” Wai Lee, co-head of Research for the Systematic Edge team at Allspring Global Investments, said in an interview with [i3] Insights.

“We had zero to negative interest rates post GFC, whereas the COVID shock ensured that your short-term interest rate was much higher than before. And when we think about institutional investors, such as public pension plans and endowments, many of them have a targeted range, if not a precise number, of returns or distributions, be it 7 per cent returns or 5 per cent distributions. In this case, the cash [rate] can become a headwind or a tailwind,” he said.

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Our cash return assumptions have moved from about 1.5 per cent at the end of 2021, to now around 4 per cent. So that 2.5 per cent uplift really makes life a bit easier – Wai Lee

For an institutional investor with a target rate of return of 7 per cent, the difference between a cash rate of zero and a rate of 4 per cent is enormous and impacts the level of risk they have to take on to achieve their targets significantly.

At a zero cash rate, investors are almost completely reliant on riskier assets, such as equities and private equity, and taking more active risks to achieve their goals.

But now that the cash rate has increased significantly post COVID, a 7 per cent return target has become much more achievable.

“Our cash return assumptions have moved from about 1.5 per cent at the end of 2021, to now around 4 per cent. So that 2.5 per cent uplift really makes life a bit easier,” Lee said.

“We think more investors can now be a bit more conservative in their risk taking and put more reliance on fixed income. Your efficient frontier has moved to the northeast from the time when cash rates were low, which means targeted-return investors can now count on a more modest risk portfolio with likely more fixed income in there to achieve the same targeted return, when they had almost no choice but to bet on higher risk [assets] and with higher active risks,” he said.

Funding the Transition

But as higher cash rates provide some relief for investors, the risks associated with climate change are increasingly more visible in markets and the impact on economies is more profound.

“We have seen severe weather events increase in frequency and cause more widespread damage. Yet, these events are unpredictable in both their occurrence and the impact they have on the broader economy,” Lee said.

Higher economic activities with more emissions can intensify climate risks, whereas climate risks can change the economic path. He illustrates his points with a personal experience of the latter.

“Hurricane Sandy in 2012 basically shut down Manhattan for a week. No power, nothing. And you could imagine the city was dead. There was no economic activity,” he said. “It was climate uncertainty that brought down the economy.”

This makes the case for taking some risk of the table through increasing fixed income allocations all the more pertinent.

But fixed income does not only play a key role in building resilience in an investment portfolio at an asset allocation level, it also has an important role in funding the energy transition to combat climate change, Henrietta Pacquement, Head of the Global Fixed Income team and the Sustainability team, as well as a senior portfolio manager at Allspring Global Investments tells [i3] Insights.

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Although historically, a lot more has been done on the equity side; actually a lot of the funding of the energy transition is going to come from the fixed income markets. So it's really a good place for investors to think about how they want to express their views in their portfolios, and in credit portfolios in particular – Henrietta Pacquement

“Although historically, a lot more has been done [in sustainability thematics] on the equity side; actually a lot of the funding of the energy transition is going to come from the fixed income markets. So it’s really a good place for investors to think about how they want to express their views in their portfolios, and in credit portfolios in particular,” Pacquement said.

Portfolio construction will be an important part of optimising credit exposures during the transition, she said.

“Credit is a real area of interest and one where you can make choices by funding companies that are going to be leading, and benefitting from, the transition,” she said.

It is not going to be just about changing the old economy, fossil fuel companies. It is going to be a broad-based, multi-sector investment effort, Pacquement said.

“There’s a lot of focus on utilities, there’s a lot of focus on energy, but actually you have sectors across the board that need to adapt. The auto sector—what does that mean for them? The real estate sector, what’s that mean for them? Building materials as well. Even banks, what choices are they going to make as asset owners in terms of funding? So, you can express the theme across sectors in the credit space and really look to tilt portfolios towards companies that are making the effort going forward,” she said.

Companies that ignore the transition will expose themselves and their investors to a wide range of risks, not just climate-related, but also regulatory. Actively identifying these businesses is a key part of building a robust portfolio.

“Companies that are not looking to evolve with the trend are opening themselves up to stranded assets, to potential regulatory issues and fines,” Pacquement said.

“Some sectors may have customers that are more sensitive to climate considerations and these customers might vote with their feet. So, I do think it changes the company credit risk profiles in certain cases,” she said.

Green bonds will form part of the solution, but Pacquement said that ultimately resilience to climate change must be addressed at the overall company level. What strategy or policy a business has in place to deal with the transition is more important in its long-term survival than whether they issue an occasional green instrument.

Besides, it also helps in identifying where the best value is, she said.

“What we’re interested in is what a company’s strategy is in relation to climate change, not just the labelling of their bonds. I think that’s important because then you can look at the bonds that they issue and it’s more of a financial and relative value call,” she said.

To ensure companies get the message, Pacquement and her team actively engage with businesses and their management. Although historically many asset managers have developed engagement activities as an extension of their equities capabilities, Allspring approaches companies through both its equity and fixed income teams, pushing the issue from both sides.

“Engagement isn’t just an equity story; it’s also a fixed income one. We have natural contact points when companies come to fund in the markets, for example. We can use that opportunity to give them feedback, we can express our views to syndicates, and that gives us an opportunity for stewardship,” she said.


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