Ulf G. Erlandsson, CIO at Diem Green Credit.
The Green Bond Opportunity & Current Crisis: What's Different Now?
Episode 18 | Duration: 14 minutes
The current market volatility and COVID-19 crisis have also created unprecedented opportunities for fixed income markets and specifically - for investing in green bonds. Find out what's different now and which plan of action and post-crisis roadmap to adopt
Keesa Schreane [00:00:37] An overwhelming majority of institutional investors say the Coronavirus outbreak is already having an impact on their investing activity. And many doubt the U.S. government's ability to effectively combat the crisis. That's according to a new survey from Eaton Partners. It says that 70% say that the coronavirus outbreak is having an impact on their investment activity and their 2020 planning activity. So, joblessness, manufacturing and housing concerns, and extreme market volatility. That's what we're dealing with now. The question is, can sustainable assets provide long term benefits? And what will be the role of sustainable assets, specifically fixed -income assets in the recovery? Here to discuss this with us today is Ulf Erlandsson, CIO of Dien Green Credits. And today, we're going to discuss the changing role of green bonds. In light of the current Covid-19 crisis, the role of fixed income can play in recovery and how investors should approach the green bonds market. Ulf, thank you so much for joining.
Ulf G. Erlandsson [00:01:44] Thank you so much. Great to be here.
Keesa Schreane [00:01:46] How has the current crisis changed the way that we look at green bonds?
Ulf G. Erlandsson [00:01:54] I think it's very interesting from the perspective those green bonds have been a very popular asset class and there's been a too big demand relative to supply. But suddenly with the sort of financial crisis that's come here, there's plenty of green bonds tax out there. There's plenty of interesting investing opportunities. And we also have a situation where there is this thing called additionality with green bonds. Green bonds are actually able to finance things that wouldn't get financed otherwise. In this new situation that you are in compared to, for example, just like a month and a half ago. So that's a very big and substantial change to the green bond market.
Keesa Schreane [00:02:35] So underlying opportunities are, as you say, underlying risks versus areas that investors may want to go toward right now as it relates to green bonds. What what are we looking at for them in terms of risks as well as those areas that they may want to pay more attention to right now?
Ulf G. Erlandsson [00:02:55] So what I generally think is that you shouldn't forget that green bonds are bonds and they have the same sort of risk on an off element that any other bonds do. However, what I think has been illustrated over the past volatility is the fact that green bonds have maybe not outperformed all the upside in some sense, but you see some of the brown bonds that are exposed to fossil risks actually underperforming quite substantially. And I think that sometimes you have to take that perspective that the green bonds are more of insurance versus some of the negative tail risks rather than, you know, just making a fantastic investment in themselves. So put them in a relative stance and it becomes quite interesting quite soon, actually.
Keesa Schreane [00:03:41] So let's dig a little deeper into that. We're talking about the brown bonds. So let's talk about those investors who possibly were able to short, you know, a few weeks ago and where they were then versus where they are now. You and I talked a bit about the rating, for example, for Exxon on where it was a couple of weeks ago and what is the expectation for them to have those types of ratings moving forward. So let's talk about brown bonds specifically and what the risks were a couple of weeks ago and then what the risk might be now and what your expectations are long term.
Ulf G. Erlandsson [00:04:16] Just a couple of weeks ago, we would see, you know, high rated bonds such as, you know, Exxon and other of the oil major, being this sort of the triple-A or Double-A type of rating category. They would be tightening quite tightly. Quite low spreads essentially. And there's been a very substantial move out and spreads on these bonds. And I think I can even actually on the relative sense, can always go back to the equity market. If you look at the just equity of Exxon, for example, right now it's down 47% this year, whereas the Dow Jones index is down 32%. And there's been this correlation between not only the corona crisis, but also the OPEC and sort of the oil glut initiated by the Saudis. And this has made it like a perfect storm in terms of tail risks when it comes to some of the oil majors and the oil industry in general. And that's just going to have repercussions for a long time. I think, you know, any risk manager in the next decade or so, looking back at, you know, the big risk that we saw out there, which was March 2020. They will also see that, you know, these types of assets actually strongly underperform, especially in the case when you didn't want things to underperform. So the repercussions of that is going to be big.
Keesa Schreane [00:05:37] Then you and I also discussed that some of the valuation impacts and I'm you know, I'm fairly confident in my view that we are going into an energy transition over the next couple of decades. I really hope so for the sake of my kids. And then you look at the name like Exxon, you know, the triple-A emblem of the U.S. and global credit markets, essentially, and they have been sliding on rating. So I think that, you know, by the end of this year, Exxon will not have a triple-A rating anymore. And I don't think they will ever actually recover that rating, given the business model they are projecting right now. So there is a certain valuation standpoint. You can do that on terms of the bond valuations and bond curves, et cetera.
Keesa Schreane [00:06:21] So if we're talking about looking at fixed income, if we're looking at the major brown players when it comes to the companies that are fossil fuel, we think about fossil fuels. We think of these companies. What can institutional investor switching gears a bit here from fixed income; institutional investors who are looking for high dividend yields and now we're talking about fixed income. I'm just going to flip the script a bit and talk about equities. What can they do moving forward? I mean, do we think that these oil companies will be able to produce the same dividend yields that equity investors had known them for years? Or do you see that as changing as well in the equities market?
Ulf G. Erlandsson [00:07:04] Well, I have a specific investment hypothesis here from my side, and that's taking it from the war, the long, short hedge fund perspective. If you look at that, again, a company that Exxon, I think at the current valuation, they're paying something like a dividend yield, implied dividend yield of over 10%. And then you compare that with regards to the sort of the yields that you get, though, the spreads that you get if you invest on the credit side, which is now pretty small compared to what you have on the dividend yield side. I mean, one thing one could argue here is why don't you invest a small sliver in the equity side? You work the case for these companies that you actually don't want, that you want them to cease with their activities. You act in a way that they actually keep paying out high dividends rather than invested in CapEx. And if they run out of money, well, then you ask them to actually borrow money. And the credit markets, you put on a short on the credit side and you slightly long on the equity side. And you can start actually playing around with this in a more creative manner. I think that just, you know, invest or divest in the traditional ESG investment style.
Keesa Schreane [00:08:20] OK, great, great. So short on the credit side and just slightly longer on the equity side, that will be your solution for that.
Ulf G. Erlandsson [00:08:26] Yeah. The dividend yield pays a lot of your costs of being short or actually you can lever up the short side a lot. Given that dividend yields are so high on the equity side and it's essentially making the company pay you for being short on their bonds.
Keesa Schreane [00:08:45] Nice. Great. Well, I want to switch gears back to go back to the fixed income markets we're just talking about. But appreciate that pivot. They are very interesting when we look at institutions. So the super nationals and the sovereign funds, where do you think their role is in terms of stepping in right now to help with their recovery?
Ulf G. Erlandsson [00:09:07] So I think they have a very big role to play here. There's been a fair number of commitments, public and non-op0-rpublic over the past year or several years from various public institutions to invest much more in green bonds. A lot of these institutions have run into a hurdle or an obstacle in the sense that there hasn't been enough supply in the green bond market. It has looked quite expensive. Now is the time when they can actually step up. And we have an example in Scandinavia, something called the Nordic Investment Bank. They committed five hundred million euros to buy green bonds by November last year. They had one hundred and thirty million invested. I mean, if there is a time when they should put their money to work, it should be at all. Both. I think and that's myself, as, you know, training as a trader. Speaking, I think the valuations are very interesting for them to do it now. And it's also this time when the market and the issues of this green capital, they actually need the support. So I think it's extremely important at some of these institutions step up and that they do it quickly rather than wait six months because we don't know what the situation is going to look like. Then the opportunity might have been missed already.
Keesa Schreane [00:10:24] Absolutely. Absolutely. And taking this just a step further and talking about where we are, where the market is in the context of the U.N., SGS, the UN Sustainable Development Goals. What do you think the role maybe for the SCD to play in terms of guiding us toward a recovery? Do you see there is a role, first of all. And if so, what is that?
Ulf G. Erlandsson [00:10:49] I think they definitely do have a huge role to play in this recovery. I don't see that, you know, playing such a big role when it comes to straight investment activities in terms of portfolio management, et cetera. It's just too volatile, there's too much happening and there's it's too hard to sort of nail down some of the S.G. G effects quantitatively into a portfolio. It's very important for investors to engage and work with the company. So they actually act in a sort of a social and SDG compliant way in the recovery process. But it's not something which is directly investable. But I do think that the climate dimension is where it's actually already investable, where there is an asset class and there is a sort of good division between good and bad assets. And you can reallocate your portfolio right now. So on the sort of the climate-related, I think it's SDG 13. It's definitely something where you can put a lot of weight right now.
Keesa Schreane [00:11:49] Absolutely. Yes. And in terms of the road map, if you had to give 3 top areas that institutional investors should consider for their post-crisis road map, what would those top three areas be at those top three things? And this can be in the context of the fixed income markets.
Ulf G. Erlandsson [00:12:08] So, I mean, my first takeaway is returns. This is an opportunity. I think it should be invested because it just looks quite attractive in the green asset class will grow immensely over the next decade. So you better be ahead of that curve rather than behind it. The second part I'd like to say something about this. You know, almost from a quantitative risk matter, what we've seen going through the markets will affect how we allocate risk and risk budgeting over a very long time. So you will see certain type of assets that got hit badly to actually be much less attractive coming out of this than they were going into it. So that's a conclusion you can start drawing, battled ready and sort of re-allocate your portfolio. Lastly, I also think, you know, fiduciary risk used to be this sort of almost...We cannot do anything but look for risk return on sort of one month rolling basis. Now we witness, you know, the biggest tail risk since the great financial crisis. We have to start thinking about how do we implement tail risk hedges in terms of our fiduciary duty as well. It's how it has to be part of that discussion. And I think, you know, tail risk hedging vis-a-vis climate risk, for example, is something that we should be a part of their portfolio and should be only enhanced by this greater focus on fiduciary duty in a broader sense.
Keesa Schreane [00:13:44] So first of all, green assets growing over the next decade is your prediction, really changing how we allocate risk and looking at the assets that are maybe a little less attractive than they were before. And then finally, fiduciary risks, specifically tail risk hedging. Great. Top three points. Ulf, thank you so much for joining us.