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Green horizons: How the shift toward sustainable finance may reshape fixed income markets

Campe Goodman, CFA, Fixed Income Portfolio Manager
Anand Dharan, CFA, Investment Director
2024-08-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Key points

  • Three distinct sustainability-related trends have the potential to transform fixed income markets, leading to a range of new investment opportunities.
  • The resulting variety of innovative debt instruments could enhance the risk/return characteristics of many fixed income portfolios.
  • Asset managers with deep experience in both traditional and sustainable debt investing can play a significant role in the evolution of these markets, in ways that best serve investors’ long-term financial objectives. 

We believe that the growing focus on sustainability could inspire financial innovation that widens and diversifies the universe of economically attractive securities. As the potential for competitive returns on investment for funding sustainable objectives becomes apparent to more market participants, we expect to see novel markets and financing structures that may improve the risk/return profiles of many traditional fixed income portfolios. We see three sustainability trends with potentially substantial implications for fixed income markets:

  • Global shift toward green industrial policies
  • Emergence of sustainable financing innovation
  • Accelerating momentum for disclosure and standardization

Global shift toward green industrial policies
As awareness of the risks of climate change intersects with national security concerns in an uncertain geopolitical environment, governments are intensifying their push to fast-track domestic low-carbon energy transitions. Notable legislation such as the US Inflation Reduction Act, REPowerEU, and the EU Green Deal Industrial Plan are steppingstones in this transition. These initiatives seek to fuel private investment in climate technology and infrastructure projects, using public funds and financial incentives as catalysts. Their aim is to build robust, homegrown manufacturing and financing capabilities within their borders that connect environmental stewardship to economic and energy security.

By enhancing the economic appeal of private-sector projects, these new policies are attracting private capital via a variety of project-based debt-financing structures. As a result, opportunities abound for fixed income investment, for projects geared toward transforming existing infrastructure to support electrification, reduce carbon emissions, and enhance climate resilience. Encouraging more widespread private-sector lending in these areas could also result in new types of securitizations connected to sustainable projects.

With policy changes potentially expanding the issuance of debt to finance the energy transition, how might fixed income markets react to rising supply? We predict that two dynamics may counterbalance the resulting upward pressure on yields and spreads. First, although the supply of sustainable debt may be growing, so is demand for that debt. Second, governments' vested interest in the success of green projects suggests that, on balance, these projects should have lower credit risk than markets currently perceive. Over time, we expect that these qualities will be able to support tighter credit spreads. 

Emergence of sustainable financing innovation
Market participants appear increasingly willing to think creatively about scaling up sustainable funding in ways that acknowledge governments’ fiscal limitations (particularly in emerging markets) and private investors’ risk-adjusted return requirements. Tackling these financing challenges could broaden the fixed income opportunity set, as potential recipients of this financing, such as sovereign and quasi-sovereign entities, primarily access public capital markets via fixed income issuance. We suspect these issuers would welcome innovation that expands their market access.

Because fixed income markets are diverse and allow for a variety of structures and issuer types, they are fertile ground for innovation in sustainable finance. Novel financing approaches may include:

  • Public/private partnerships that direct sustainable financing to emerging markets, including to create local capabilities for originating and securitizing sustainable project debt
  • Reinsurance solutions with payouts linked to borrowers’ successful climate mitigation or resilience measures
  • Financing structures like blue bonds or natural-capital-backed debt, which not only reward stewardship but also can help quantify the economic value of critical but hard-to-price public goods  

Because these new structures may have low correlations with traditional fixed income securities, they might also unlock new opportunities to improve portfolios’ risk/return characteristics.

Accelerating momentum for disclosure and standardization
Complementary efforts from the public and private sectors are driving new levels of transparency and comparability among fixed income securities’ sustainable characteristics. On the public side, a growing number of countries across Europe, the Asia-Pacific region, and Latin America are adopting robust classification schemes to guide market participants in determining the extent to which financial instruments support sustainability objectives.

At the same time, private organizations like the International Capital Markets Association (ICMA) and the International Sustainable Standards Board have responded to investor demand for transparency. These institutions have introduced new disclosure standards and updated existing frameworks, extending them to noncorporates. ICMA’s latest revision of the Climate Transition Finance Handbook, for example, now includes guidance for sovereign issuers.

Over time, such standardization should equip asset managers to engage more effectively on sustainability topics with a greater variety of noncorporate issuers. This could be a game changer: By broadening the spectrum of noncorporate securities eligible for sustainable or impact-focused fixed income portfolios, investors can, again, amplify their diversification and risk-adjusted return potential while staying committed to sustainability. 

Asset managers’ role in this evolving ecosystem

We envision diversified asset managers playing a pivotal role in the evolution of sustainable fixed income markets, helping ensure that the resulting financial innovations meet investors’ financial objectives while contributing to sustainable outcomes. Asset managers can support the development of sustainable fixed income markets in three main ways:

  • Impact measurement and management. Managers can offer vital quality control as new markets and security types emerge. By looking beyond labels and leveraging industry- and country-specific knowledge, they can assess whether new issuances support measurable, additive sustainable objectives.
  • Product development. By bridging the gap between financing needs and sources of capital, managers can ensure that new sustainable financing structures match the investment objectives, risk tolerance, and return requirements of a diverse set of investors, thereby expanding the market for sustainable investment solutions.
  • Convening ability. Financing sustainable outcomes is a complex, multidisciplinary challenge. It requires collaboration between investors, scientists, policymakers, standard setters, and nongovernmental agencies on a global scale. Large asset managers who interact extensively with these diverse stakeholder groups are in a prime position to help shape sustainable fixed income markets in ways that deliver financial benefits to investors and support sustainable outcomes.

Closing thoughts

The potential to generate attractive returns by investing in securities that support sustainability objectives — from mitigating climate-related financial risks to expanding internet access or financial services or health care for billions of people — is growing. It is clear to us that fixed income markets hold the key to financing enduring progress on these objectives. We also believe sustainability will drive financial innovation, influence policymaking, and reshape the fixed income investment landscape. The evolution we have witnessed in green policy, blossoming interest in sustainable financing innovation, and accelerating pace of disclosure and standardization all signal a profound transformation. As asset managers, we believe our role is to leverage our expertise and networks to ensure that the growth of sustainable finance produces better investment outcome for our clients and underpins a sustainable future.

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