Author Details

Bruno Rauis

Bruno Rauis
Executive Director, MSCI Research

Juan Sampieri

Juan Sampieri
Vice President, MSCI Research

Andy Sparks

Andy Sparks
Managing Director, MSCI Research

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Why Is Climate-Transition Risk High in High Yield?

  • We considered the transition risk of select U.S. corporate-bond and equity benchmarks under a climate-policy scenario designed to limit the increase in global temperature to 1.5° Celsius by the year 2100.
  • Counter to expectations, the high-yield-bond benchmark had the highest exposure to transition risk, owing to the relatively large proportion of high-yield bonds in the energy and materials sectors.
  • We constructed hypothetical high-yield portfolios with significantly reduced levels of transition risk and with limited tracking-error risk.

Institutional investors are increasingly focused on building greener portfolios, with reduced exposure to climate-transition risk. Some might expect bonds to be less exposed to this risk as compared to equities, due to the seniority afforded to bonds by the capital structure. Yet that logic doesn’t necessarily hold at the portfolio level: Stress testing U.S. equity and corporate-bond benchmarks under a 1.5˚-Celsius (1.5°C) climate-policy scenario revealed that the high-yield benchmark had more downside repricing potential than the equity benchmark.

 

Climate-Transition Risk: The Role of Capital Structure

We considered investment-grade- and high-yield-bond issuers that also have listed equity. We used the MSCI Climate Value-at-Risk (Climate VaR) Model to assess how their equity and bonds might be impacted by a climate-policy scenario designed to limit the increase in temperature to 1.5°C.1 Since an issuer’s equity securities are the first exposed to the downside impact from climate, and bonds get impacted thereafter, we expected equities to carry more transition risk. Our results confirmed this intuition, as the equities had substantially more downside valuation impact under this climate scenario than their bond counterparts: The median ratio between equity and bond Climate VaR was around 15 times, and in 25% of the cases it was more than 40 times.2

If, at the issuer level, bonds tend to carry less climate-related downside risk, would bond benchmarks also be less exposed to climate risks than an equity benchmark?

Counter to expectations, we found that the benchmark for high-yield corporate bonds showed far greater exposure to climate-transition risk (as shown in the exhibit below), with a Climate VaR of -12.7%. The equity benchmark had a Climate VaR of -5.9%, while the investment grade-corporate-bond benchmark showed the lowest level of transition risk (-3.4%).

 

Sector Concentration Drove Lopsided Differences in Climate-Transition Risk

 

The U.S. equity market is represented by the MSCI USA Investable Market Index. The investment-grade and high-yield corporate-bond markets are represented by the MSCI USD Investment Grade Corporate Bond Index, respectively. And the MSCI USD High Yield Corporate Bond Index. Based on data as of April 30, 2021.

 

Importance of Sector Concentration

Corporate-bond and equity benchmarks differ significantly in sector concentration. While the equity benchmark has more than a quarter (26%) of its market value in the information-technology sector, the high-yield benchmark has over a quarter (27.1%) of its market value in energy, materials and utilities — three sectors traditionally associated with high climate-transition risk. Energy alone represents 14% of the high-yield benchmark’s market value, driving nearly half of the benchmark’s transition risk.3

 

Building Climate-Aware High-Yield Portfolios

We then considered a hypothetical fixed-income portfolio manager with a high-yield benchmark denominated in USD, who wanted to integrate climate-scenario analysis into the investment process. The manager’s goal was to create portfolios protected against the transition risk of a 1.5°C climate-policy scenario, without deviating too far from the benchmark’s risk characteristics.

We used optimization techniques to construct three hypothetical portfolios based on different levels of tracking-error risk relative to the benchmark.4 As shown in the plot below, the portfolios had significantly improved potential valuations under the assumed climate scenario. The right-hand side of the plot shows that the portfolios’ climate-risk contributions from the energy and materials sectors were substantially decreased.

With only 20 basis points of tracking-error risk to the high-yield benchmark, Portfolio 1 noticeably decreased its potential loss in value from -12.7% to -1.7%, while keeping the portfolio-level option-adjusted spread and effective duration almost the same as those of the benchmark. Portfolio 2 offered an additional decrease, to -0.4%, in its potential loss — but at a “cost” of greater tracking-error risk. Portfolio 3 offered only a relatively small decrease in the potential loss.

 

Improving the Climate Profile of High-Yield Portfolios

 

The high-yield corporate-bond benchmark is represented by the MSCI USD High Yield Corporate Bond Index. Based on data as of April 30, 2021.

 

Implications for High-Yield-Bond Managers

Our model-based analysis showed that the U.S. high-yield benchmark had significantly greater exposure to climate-transition risk than U.S. equity or investment-grade corporate-bond benchmarks.

Our results also show that it might be possible to build greener high-yield portfolios without deviating too far from the benchmark’s risk characteristics, by surgically removing the exposures to issuers in sectors (such as energy, materials and utilities) with high climate-transition risk.

 

 

1MSCI’s Climate VaR Model provides bond- and equity-level estimates of the potential valuation impact of a given climate scenario. For this analysis, the Climate VaR metric assumed a 1.5°C temperature-rise scenario by the year 2100 and consisted of two components: the Policy Risks Climate VaR, which measures the potential losses due to future climate policies, and the Technology Opportunities Climate VaR, which measures the potential valuation upside from innovations in low-carbon technologies. The Climate VaR transition risk assessment equals the sum of the Policy Risks Climate VaR (always negative) and the Technology Opportunities Climate VaR (always positive).

2We started with the group of issuers represented in the MSCI USD High Yield Corporate Bond Index and the MSCI USD Investment Grade Corporate Bond Index and excluded those issuers whose equity was unlisted. This group thus only contained issuers that have issued both equity and bonds in the public markets.

3The MSCI Climate VaR calculation uses a sector classification based on the sector of the listed equity. A small number of bond issuers have multiple sector classifications, depending on the subsidiary that issued the bonds. In such cases, the issuer typically has one sector classified as financials. To be consistent, in our analysis we used the listed-equity sector for those companies with bonds issued in multiple sectors, including financials.

4Specifically, we used MSCI’s Barra® Open Optimizer and the long-term version of the MSCI Multi-Asset Class Factor Model. The optimizations maximized the sum of the Policy Risks Climate VaR and the Technology Opportunities Climate VaR metrics, subject to a given level of portfolio tracking-error risk and other constraints. Tracking-error risk (also known as active portfolio risk) is the projected annualized volatility of the difference in returns between the portfolio and the benchmark. We also required that the duration times spread (or DTS) in each Global Industry Classification Standard (GICS®) sector was the same between the portfolio and the benchmark. GICS is the global industry classification standard jointly developed by Standard & Poor’s and MSCI. To avoid issuer concentration, issuer weights in the portfolio were also constrained to be less than or equal to 3%.

 

 

Further Reading

Climate Transition and Bonds: Risk or Opportunity?

Foundations of ESG Investing in Corporate Bonds

The Role of Capital in the Net-Zero Revolution

How Have Stocks Responded to Changes in Climate Policy?

Stress Testing Climate-Change Scenarios

Regulation