ESG Considerations for Fixed Income – Yield-Curve Strategies
June 15, 2021
One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.
Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.
Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked [1].
In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.
Introduction
In this thought-leadership piece, we provide the reader with an overview of yield-curve strategies for fixed income and the link to ESG investing. We begin by discussing some of the foundational yield curve strategy concepts used by asset managers. First, we provide an overview of the major types of yield curve strategies including a discussion of the carry trade. This is followed by outlining some of the motivations for altering portfolio convexity and the derivatives products used to implement yield curve strategies. We conclude with a discussion of inter-market curve strategies followed by the all-important question of what the implications for ESG investing might be. Unlike other credit strategies, the implications for ESG investing are not straight forward, but there are unique insights that can be gained by understanding the motivation and tools for the investment manager.
Before we dive into yield curve strategy concepts, it might be helpful to answer the question: What exactly is the yield curve? The yield curve is a graph that plots the relationship between bond yields and their time to maturity. Often, as investors commit to a longer time horizon, they demand a higher yield. Typically, the yield curve is upward sloping. The shortest bond maturities on the yield curve are typically one year and the longest maturities are typically 30 years. The yield curve may be used by investment managers to forecast interest rates, price bonds, or create strategies for boosting total returns. Strategies for boosting returns are the primary concern for the discussion in this newsletter. The yield curve is also commonly used as a leading indicator of economic activity. You may have heard that a “yield curve inversion” is a signal of an economic downturn. Typically, a yield curve will become inverted 12 to 18 months prior to an economic recession [2]. In short, pay attention to the yield curve. It is important.
Major Types of Yield Curve Strategies
A yield curve that is upward sloping and stable is conducive to several different strategies. The investment manager can choose a buy and hold strategy. This strategy is predicated on the fact that a long duration bond will earn a higher yield than a short duration bond. The manager can profitably “roll down the yield curve” or “ride the yield curve” whereby the manager sells a bond and then buys it back later when it is worth less (has rolled down in price). Rather than ride the yield curve, an investment manager can also implement a carry trade when the yield curve is upward sloping and stable. A carry trade involves borrowing at a low, short-term interest rate and investing at a high, long-term interest rate. A carry trade can also be done by entering into an interest rate swap to pay fixed and receive floating or by taking a long position in a bond future contract. Another strategy for an upward sloping stable yield curve is to sell convexity. We will discuss convexity more in the next section.
What if the yield curve is not upward sloping and stable? If the yield curve is expected to undergo a parallel shift up, the investment manager should decrease duration. If the yield curve is expected to undergo a parallel shift down, the investment manager should increase duration. If the shift is expected to be very large (in either direction), the investment manager should increase convexity. Convexity will result in a lower yield but will increase returns if the shift is large enough. Changes to the yield curve are not always parallel. The yield curve can also undergo a change in level, slope, or curvature. In these cases, the investment manager will need to manage duration across the yield curve and increase exposure to key rates where the interest rate is expected to decrease. A bullet portfolio which is long a mid-maturity bond and short a near-term and long-dated bond will concentrate duration around the portfolio duration, lower convexity, and benefit if the yield curve steepens. A barbell portfolio offers the manager a profitable strategy if the yield curve is expected to flatten. The barbell concentrates duration around the ends of the yield curve and has higher portfolio convexity. Key rate durations can be used to estimate a bond or portfolio’s sensitivity to changes in the shape of the yield curve as well as to identify bullets and barbells.
Motivations to Alter Portfolio Convexity
As mentioned above, an investment manager is likely to increase portfolio convexity when large interest rate changes are expected. Positive convexity will magnify the upside and reduce downside, but this comes at a cost, as convexity will reduce yields. When an investor expects market volatility to be greater than the rate of volatility that is currently implied by the market, the investor should add convexity. There are several different ways that portfolio convexity can be altered. A barbell strategy can be used to increase portfolio convexity while a bullet strategy can be used to decrease portfolio convexity. Options on bonds can also be used. A call or put option on a bond will increase convexity. If the investor sells a call or put option on a bond, this will decrease portfolio convexity. Bonds that have embedded options will increase portfolio convexity if the investor is long the option (in the case of a putable bond) or decrease convexity (in the case of a callable bond). A mortgage back security is an issuer option that means the holder of the security is short the option and therefore, short convexity.
Using Derivatives to Implement Yield Curve Strategies
We have already touched on motivations for altering portfolio duration due to anticipated changes to the yield curve, but what are the tools available to the investment manager to implement these strategies? Often, derivatives are used to implement yield curve strategies. Adding bond futures to a portfolio will increase the duration. The targeted basis point value (a measure of duration) less the current portfolio basis point value, per basis point value of the futures contract being added, will yield the number of contracts that the investment manager needs to purchase. The basis point value is calculated by determining the monetary value of the position multiplied by modified duration per 10,000 basis points. Options are another pathway of altering portfolio duration. An investment manager can increase duration by adding a call option to a bond. The investment manager can also use leverage to increase portfolio duration. The last tool that we will discuss is the swap. The investment manager can increase portfolio duration by entering into a swap to receive a fixed-rate payment and pay the floating rate. This is equivalent to borrowing at the short-term interest-rate and buying a fixed rate bond. The notional value of a swap is equal to the desired change in the portfolio basis point value per the basis point value of the swap. The basis point value of the swap is the difference between the fixed and floating side basis point value. The desired change in basis point value is the difference between the liability and asset basis point value for a given portfolio.
Inter-market Curve Strategies
Investment managers may be motivated to profit from differences in yield curves across markets. This is referred to as an inter-market yield curve strategy. There are several strategies the manager can undertake if they are not concerned with currency risk. The manager can borrow in a low interest rate currency, convert the funds to a higher interest rate currency, and invest at that higher rate. A second method is to enter into a currency swap to pay the low interest rate and receive the high interest rate. A third method can be applied in a high interest rate market and involves borrowing at the short end of the interest rate curve and investing at the long end of the curve. The manager then converts the financing to a lower rate currency through the foreign exchange forward market. This involves buying the higher rate currency forward.
If the manager wants to enter into an inter-market strategy without currency risk, they can enter into a swap to receive a fixed payment and pay the floating rate in a steeper market while simultaneously entering into another swap deal to receive a floating payment and pay fixed in the flatter market. Alternatively, the manager can use bonds to replicate the four positions taken with the two swaps described above. The manager will go long a fixed rate bond and short a floating rate bond in the steeper market while also going long a floating rate bond and short a fixed rate bond in the flatter market. The third tool that allows a manager to implement an inter-market curve strategy without currency risk is to buy a bond future in the steeper curve market and sell a note future in the flatter curve market.
Implications for ESG
Having covered some of the foundational concepts of fixed-income yield curve strategies, we now turn our attention to ESG and sustainable investment considerations. Utilizing active yield curve strategies can yield benefits to investors even when central bank policy rates are low, as is the case with the European Central Bank (ECB). Low or negative yield environments still offer profitable trading opportunities and benefits in the form of diversification, capital preservation, and income.
One potential strategy is to roll down the German curve [3]. German Bund yields are very low, but the curve is steep compared to other yield curve markets. This offers an opportunity to capture a structural source of return. Investors can “roll down the curve” by buying a bond at a steep point in the curve and benefiting as time goes by and the yield drops. A drop in the yield will lead to an increase in price. This process can continue as long as monetary policy does not change dramatically, and the ECB is able to maintain its long-term credibility. This is where an ESG investing lens can be useful. The same diligence process used to assess corporate governance risk at the security level can also be applied to monetary regimes. Political instability resulting in exogenous shocks can create credit risk for sovereign bonds. These shocks can cause the yield curve to move in unexpected ways. If an investor is looking to implement an active yield curve strategy such as a roll-down strategy or carry-trade, the investor should undertake due diligence on potential risks to the sovereign entity. Risks associated with yield curve changes are often due to economic growth, fiscal policy, monetary policy, and inflation, but each of these drivers could be altered by environmental, social or governance factors.
Conclusion
As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.
References
- https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
- https://www.pimco.com.au/en-au/resources/education/investment-basics-yield-curve/
- https://www.pimco.dk/en-dk/insights/investment-strategies/featured-solutions/alpha-opportunities-in-european-fixed-income-without-adding-risk
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