Debunking a myth about fossil fuels and sustainable fixed interest

Exclusion of fossil fuels presents minimal challenges for sustainable bonds compared to other asset classes, writes Pendal head of credit and sustainable strategies, GEORGE BISHAY  

• Sustainable portfolios across asset classes have generally excluded exposure to fossil fuels. This means some asset classes may face additional benchmark-relative risk by adopting sustainable strategies.
• There is a perception that all asset classes face these potential performance risks when prioritising sustainability. But Pendal demonstrates there is minimal impact on the performance of sustainable, active, fixed income in Australia compared to other asset classes when fossil fuel prices rise and fall.  
• Unlike some other asset classes, a sustainable approach to Australian fixed income adds minimal, if any tracking error when screening out fossil fuel exposure
• Find out more about Pendal Sustainable Australian Fixed Interest Fund

SUSTAINABLE funds typically screen out industries such as fossil fuels, tobacco, weapons, alcohol, gaming, pornography and uranium mining.

This is generally with a revenue threshold, where companies with a certain level of revenue linked to a particular activity are screened out.  

Different asset classes have different potential exposures to fossil fuels.

Fossil fuel companies typically make up a large part of equities indices (about 15 per cent of the ASX 300 in July 2024).

By contrast, issuers involved in fossil fuel extraction, exploration or refining are a small component of the Australian fixed-income benchmark.

Chart 1 below shows these issuers make up only about 0.1 per cent of the Australian fixed income benchmark, according to the rules applied to Pendal Sustainable Australian Fixed Interest Fund (see Chart 1 footnote below).

However, there can be variations in the exclusions of different funds.

For example, in Australian equities a fund’s revenue threshold can dictate whether a company such as BHP (at about 9% weight in the ASX300 index) is included or not.

BHP’s revenue includes coal mining. Other iron ore miners such as Fortescue Metals and Rio Tinto are not typically excluded.

Notwithstanding these variations in exclusions, active performance in the average sustainable equity fund is influenced by changes in oil prices.  

As a result of these differing levels of benchmark exposure, sustainable fixed-income portfolios in Australia are less sensitive to the movements in oil prices than equity counterparts.  

What drives the active performance of Pendal Sustainable Fixed Interest Fund?

Active credit management is the main driver of excess returns in Pendal Sustainable Australian Fixed Interest Fund.

Pendal Sustainable Australian Fixed Interest Fund

An Aussie bond fund that aims to outperform its benchmark while targeting environmental and social outcomes via a portion of its holdings.

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The green circles in the chart below highlight periods when the manager’s active de-risking and re-risking of its credit exposures process led to strong outperformance.  

These returns are driven by active management and are delivered despite rising oil markets.

The black circle highlights a period of rising inflation concerns due to Covid supply chain issues driving goods inflation and central bank hiking fears.

This led to a risk-off event in credit markets which saw most active fixed-income funds underperform the benchmark. 

Given the volatility of oil markets, Pendal Sustainable Australian Fixed Interest Fund has delivered consistent returns, outperforming its benchmark in 75%¹ of months since inception to July 2024.   

The chart below illustrates the number of excess return months under different buckets of excess returns.

Social and environmental benefit + portfolio diversification benefit

Many sustainable fixed-income investors are attracted to ESG-labelled bonds which aim to address green, social and sustainability issues.

The proceeds of these bonds are usually ring-fenced for specific environmental or social projects to support climate stability and/or the underserved in society.

The Australian ESG labelled fixed-income market was valued at some $A124 billion in August 2024, constituting 7.6% of the total Australian fixed-income benchmark.

The ESG-labelled bond market offers sustainable Australian fixed interest managers exposure to an additional opportunity set beyond traditional fixed income – environmental and social projects across varying sectors, credit qualities and tenors.

These labelled bonds can complement an overall fixed-income portfolio, bringing added diversification benefits.

The credit spread on these bonds may not directly follow the credit spread on an equivalent vanilla bond issued by the same issuer. This arises from the different technical supply and demand factors affecting these types of bonds.

These bonds are desirable and often in greater demand than vanilla counterpart bonds.

The Australian fixed interest market has ESG labelled bonds in 13 of its 14 sub-sectors (transport is the only missing sector), providing investors with the ability to diversify across numerous sectors.

In August 2024, the Pendal Sustainable Australian Fixed Interest fund held more than 66% in ESG-labelled securities.

Sustainable fixed income as part of your core fixed income allocation

Unlike sustainable equities, which may underperform during periods of rising oil prices, Australian sustainable fixed-income exhibits minimal sensitivity to oil markets or any other screened activities.

This differentiation allows investors to integrate sustainable fixed income into their overall core fixed interest allocation with minimal additional benchmark risk.   

By incorporating Australian sustainable fixed income alongside other traditional assets, investors can achieve a robust portfolio while also supporting climate stability and/or the underserved in society.

¹ Pendal Sustainable Australian Fixed Interest outperformed the Bloomberg AusBond Composite 0+yr in 72 of 96 months from inception (Aug-16) to July 2024, gross of fees.    

Find out more

Pendal Sustainable Australian Fixed Interest Fund is an Australian bond fund that aims to outperform its benchmark while also seeking investments in securities that target environmental and social outcomes.

The Fund is designed for investors who want income, diversification across a broad range of fixed income securities and are prepared to accept some variability of returns.

It is one of the few sustainable fixed-income offerings in the Australian market.

The fund is managed by Pendal’s head of credit and sustainable strategies, George Bishay. George holds a wealth of experience in portfolio management and credit analysis.

With over three decades working in financial markets, he has worked across numerous fixed income, credit and money market portfolios in portfolio management, credit analysis and dealing roles. He has managed dedicated sustainable fixed-interest portfolios for more than 15 years.