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Our views 19 July 2021

JP’s Journal: Don’t judge a bond by its label

5 min read

Two years ago I had a lovely holiday cycling down the Mosel; good exercise, great scenery and fantastic wine. We ended up in Aachen, full of history and a great reminder that the European borders we see today are relatively new.

I am reminiscing because of the flooding in Western Germany and Belgium. Let’s hope for a quick recovery. But events like this will heighten discussion on climate change and how financial markets can help transition to a lower carbon future.

I am glad, but not complacent, to say that Royal London has been at the forefront of responsible investing in equity and debt markets. Some of you will be familiar with my colleagues Mike Fox, Shalin Shah and Ashley Hamilton Claxton. I think they have done a great job in raising awareness of how money can be deployed to companies offering ESG leadership and I was pleased to see this recognised in the Investment Week Fund Manager of the Year Awards.  

From a debt perspective the choice of green and sustainability bonds is ever growing. This gives us a dilemma: the label sounds good but what’s under the bonnet? We have written on this in the past – those interested can reference 'Getting to grips with green bonds' that we published earlier this year.

Let’s look at an example that my colleague Matt Franklin highlighted from last month. As part of wider changes to its capital structure, Anglian Water issued its first sustainability linked bond. Whilst that may sound similar to green, social and sustainable bonds, now commonplace in sterling debt markets, they are in fact quite different. The label green, social and sustainable is based on the use of a bond’s proceeds, with funds earmarked against a company’s environmental projects for example. However, sustainability Linked bonds don't look at inputs, but rather outputs. This difference is really important.

Anglian Water’s new bond clearly set out ESG targets for the company, and if these are not met then there will be an increase in the bond’s coupon. In this case, targets are based on Anglian’s net zero commitments, with the company needing to reduce carbon emissions by 30% by 2025 or face up to 25bps increase in its coupon.

Whilst green bonds sound great in theory, in practice we see several significant shortcomings. There is undoubtedly a growing tendency to buy green bonds because of label not because of their value or perceived impact. Sustainability Linked bonds are a far more interesting prospect; focusing on delivering outcomes, with issuers putting their money where their mouth is against black and white targets. Well done Anglian Water and let’s see whether this starts a new trend. For information, RLAM did not buy the new bond. We like what Anglian is doing but find better value in their existing debt. Regardless of whether a bond is green, sustainability linked or unlabelled, we believe that it is vital to do your own bottom-up analysis in order to get a true sense of a borrower’s credit and ESG fundamentals. To us, that will always matter far more than any label.

Markets and economics

It has been a pretty choppy week in government bond markets. Generally, inflation data has been stronger than expected with the US CPI hitting 5.4% and the UK RPI approaching 4%. However, there has been a difference in response. The US Federal Reserve is signalling that policy will continue until labour market conditions tighten. The Bank of England is giving out more mixed messages. Cash rates remained untroubled by this volatility whilst sterling moved a bit higher. However, the UK yield curve flattened materially with five-year rates hardening and 10 and 30-year yields falling; in the US 10-year yields fell below 1.3%. Implied inflation moved higher in most markets but remained below levels seen in May.

In terms of economic data the UK is doing surprisingly well on the employment front. Whilst the June unemployment rate increased, the number of payroll employees rose by 356,000, only 206,000 below pre-pandemic levels and for the first time some regions are now above pre-pandemic levels. Similarly, the redundancy rate decreased and is back at pre-pandemic levels whilst vacancy levels remained high. However, the real test will come in September as the furlough scheme winds down.

Investment grade credit markets continued their sideways move. In general, these markets suit our long-term strategies where extra carry and active management make a difference.  New issues are becoming a bit too hot in some instances and we continue to be selective – pulling out of more deals through the book building process.

In our global credit strategies, it is a similar picture – tightening spreads and more passes on new issues. There was an improvement in some areas of the Chinese high yield market and we were able to add to some positions in the sell-off but selection remains key here. Overall, high yield spreads were a bit wider, but indices are only a tad off their year highs.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.