Innovating in credit strategy

The following is an extract from our 2024 Solutions outlook.

2023 looks set to have been the world’s hottest year on record, with extreme weather events becoming far more frequent. We believe investors have a crucial role to play in driving the transition to a low-carbon economy and mitigating climate-related risks.

One way investors can seek to exercise this power in 2024 is by applying LGIM’s destination@risk framework. This framework enables investors to assess the climate-related risk and temperature alignment of individual companies and, by extension, make investment decisions that can both seek to reduce risk and improve the environmental impact of their portfolios.

Investors are also increasingly aware of the importance of biodiversity and in our view are turning to innovative solutions such as LGIM’s Sustainable Development Goals (SDG) alignment methodology which integrates biodiversity considerations. Biodiversity and ecosystems feature prominently across many of the SDGs and associated targets.

For example, SDG 14 – Life below water – and SDG 15 – Life on land – aim to protect and restore the natural environment and biodiversity. SDG 1 – Ending poverty in all its forms everywhere – is also closely linked as biodiversity provides resources and income, particularly for the rural poor. SDG 13 – Climate change – also has strong links given that biodiversity and ecosystems help mitigate climate change by storing and sequestering carbon.

Engagement is a powerful motivational tool that works together with innovative investor strategies. For example, our destination@risk framework assists us in identifying laggards that we can target for engagement and advocate for more ambitious and transparent climate action.

Climate laggards tend to have high carbon emissions intensity which is typically correlated with a higher expected increase in global temperatures, as shown in the example of global electricity issuers in the chart below.

Capital can be directed away from the laggards if, for example, we believe that engagement is not delivering our expected outcome and we think that issuer climate transition risk is relatively high in comparison to peers.

New ways to access credit

In addition to climate frameworks and engagement, we believe innovative investment strategies are both also required for a successful and meaningful ESG strategy. A buy and maintain portfolio is a common way for well-funded DB pension schemes to access credit. For those with limited collateral headroom, they can use:

• Corporate bond repurchase agreements (repo) for collateral management
• Committed corporate bond repo where an upfront fee enables access
• Gilt exposure collateralised by corporate bonds

We believe these tools can work well as backstops, however, there are also synthetic routes for more permanent leveraged exposure to credit spreads:

1. Index credit default swaps (CDS): Quick and inexpensive to implement; integrated matching solutions can efficiently use a shared collateral pot with an LDI mandate, or be implemented via pooled strategies

2. Bespoke synthetic buy and maintain credit: Can be implemented via single name CDS. Our experience demonstrates it has the potential benefits of a physical buy and maintain approach such as credit spread value protection, diversification (albeit a slightly smaller universe than physical bonds) and ESG integration, but with more capital efficiency. Can also offer extra credit spread compared to index CDS, due to single CDS’ higher liquidity premium

3. A hybrid approach: For example, we believe a physical bond approach excluding financials, alongside single name CDS exposure to financials, can have several potential benefits:

• Helps with security and cost of collateral adequacy, as corporate bond repo pricing for financials may be less attractive
• Helps with buy-in readiness, as insurers often avoid financials exposure, so this can be unwound easily prior to buy-in
• Capture potential relative value opportunities of single name CDS versus cash bonds

The above is an extract from our 2024 Solutions outlook.