Green gilts have a role to play in schemes’ portfolios

For pension schemes that may now be looking to green gilt issuance as a potential investment opportunity, they should consider how these assets could fit into meeting both their climate impact and other investment objectives. 

Pension schemes tend to hold gilts for two reasons: as liability-driven investment hedges, and/or within risk parity allocations.

Gilt portfolios need to be able to match both the interest rate and/or inflation sensitivity of the liabilities, while allowing schemes the flexibility to generate sufficient returns to meet their funding objectives

In their role as LDI hedges, gilt portfolios need to be able to match both the interest rate and/or inflation sensitivity of the liabilities, while allowing schemes the flexibility to generate sufficient returns to meet their funding objectives.

For most schemes, this means that a leveraged allocation is required. Therefore, gilts need to be easily financed via the repurchase market. 

In risk parity allocations, the ability to leverage government bonds either directly or through the futures market is required to reach target volatility levels.

Scheme assets dominated by long-duration bonds

LDI objectives mean that gilt holdings tend to be dominated by bonds that are long-duration, index-linked, liquid, and easy to finance. 

While bonds with less liquidity than gilts do have their place in client portfolios, they are typically within corporate bond allocations with expected returns meaningfully higher than gilts. 

For green gilts to fit within existing gilt holdings, they would need to have a similar liquidity and cost of leverage to existing conventional and index-linked gilts.  

These requirements have often meant that even government-guaranteed issuers, such as Network Rail, have struggled to become a meaningful asset allocation for pension schemes, despite offering a higher spread than conventional gilts.

Since green gilts — and green bonds in general — may be expected to have a lower yield than non-green gilts (albeit potentially only marginally), achieving climate impact objectives via green gilts may mean investors need to accept lower expected returns from their gilt portfolios. 

Allow investors to isolate impact exposure

However, if the green gilt premium is only marginal, or non-existent, this would allow for allocations within existing LDI mandates — some gilts already trade more expensively relative to others, after all — and green gilts would allow investors to isolate impact exposure without taking the credit, equity and operational risks that come with existing positive impact investments. 

While green gilts could be less liquid than other gilts, they will be much more liquid than many other investments, particularly private investments, and thus could be suitable for investors with little or no ability to allocate to investments in illiquid assets, but who still want to achieve an impact objective.

In regards to those objectives, these can be set either at the portfolio level (for example, I want my overall portfolio to reduce carbon emissions by X per cent) or at the individual fund level (for example, I want all my funds to reduce their carbon emissions).

In the case of a portfolio-level objective, a green gilt overlay strategy could be used to meet a given impact objective with minimal disruption to the rest of the portfolio, in a philosophically similar manner to an LDI overlay.

Green bonds need meaningful climate impact

The potentially negative expected return from the overlay would be offset by the higher return on the rest of the portfolio. We should note though that green gilts would need to have a meaningful and quantifiable climate impact to meet this objective.

For a fund-based objective, green gilts could enable LDI funds to meet impact goals, albeit possibly at the expense of underperforming a gilt-based benchmark due to the (anticipated) lower yield on green gilts. 

Incorporating green gilts into the liability benchmark could help alleviate this problem, along with requiring the LDI manager to hold a certain amount in green gilts, subject to matching the liability and managing the inevitable basis risk. 

Given that there are still a number of unknowns, Redington believes it is too early to come to strong conclusions on green gilts, and that any conclusions are likely to be specific to the objectives of a given investor rather than the same for all investors. 

That said, green gilts could represent an interesting avenue for environmental, social and governance, and/or climate impact objectives, to be better integrated into LDI and hedging mandates where opportunities to do so have so far been relatively limited. 

Philip Rose is chief investment officer for strategy and risk at Redington