Bonds are an ESG blind spot in investing

A strangely paradoxical feature of current markets is how global capital manages to be both supportive and subversive of the environmental, social and governance agenda that has been a central focus of investor attention around the COP26 climate change summit.

Equity funds with socially responsible investing or ESG mandates have attracted twice as much money in the year to date as their counterparts without them, according to data provider EPFR.

Yet this push for decarbonisation and social responsibility, which is as much an asset management marketing ploy as a token of virtue, is primarily an equity market phenomenon.

In the much larger global bond market, BBVA Global Markets Research has estimated that in late 2020 the stock of green, social and sustainable bonds had yet to reach $1tn out of a market total of $128tn. While this green exposure is rising fast from a low base, it is indisputably minuscule.

The great majority of this market is ethically value free. ShareAction, a non-profit responsible investment research group, found last year, for example, that 84 per cent of asset managers had no public policy against purchasing sovereign bonds from countries under international sanction for human rights abuses.

One consequence of this in the fund management fraternity is that global capital is rewarding China, the world’s biggest polluter and a country criticised over human rights. Despite increasing geopolitical tension between Washington and Beijing, foreign direct investment in China is running at record levels, while inflows into onshore Chinese debt reached $186bn in 2020.

Even after market jitters over regulatory risk arising from Beijing’s “common prosperity” agenda and rising default risk in the real estate sector, foreign holdings of Chinese bonds jumped about 30 per cent in 2021 to more than Rmb3.9tn, according to central bank figures.

For debt investors, the bait lies in the fact that the Chinese sovereign debt market has long been offering a significantly higher yield than the US Treasury market. With much lower inflation than in the US, real yields on Chinese government IOUs are also positive. So for global investors the search for yield trumps ESG considerations. At the same time, the progressive inclusion of Chinese bonds into the big global indices ensures that passive fund managers which track them continue to pour yet more money into China.

The ESG sensitivity of the global bond market is nonetheless set to increase because the advanced country central banks are committing to greening the portfolios of bonds they have acquired through their asset purchasing programmes.

China’s foreign exchange regulator’s numbers show that central banks account for $264bn of the outstanding $512bn balance of foreign held Chinese debt.

The Chinese government debt market is relatively illiquid as the commercial banks that are the chief participants in the market buy and hold to maturity. So rising central bank exposure to it reflects a growing tendency to prioritise diversification and the search for yield over liquidity and security.

It also suggests that central banks such as the European Central Bank and those eurosystem central banks that hold renminbi denominated assets may be caught in an internal green-brown carbon conflict.

Policymakers at COP26 have been looking to asset managers and owners to do much of the work on decarbonisation, both in terms of financing the overhaul of the carbon intensive capital stock and pressuring companies to aim for net zero emissions. Yet there is a limit to what they can do given that many big emitters of greenhouse gases are state owned or private and thus not much beholden to institutional investors.

In addition, fund manager BlackRock’s chief executive Larry Fink has warned that pressure on public companies to pursue net zero targets — while leaving private ones out of the spotlight — is creating an opportunity for “the biggest capital markets arbitrage in my lifetime”.

He has a point, though the transfer of dirty assets from public to private equity also entails the biggest regulatory risk on the planet. This is because the Paris and Glasgow objectives are unlikely to be achieved without more widespread use of carbon pricing which would severely impair the value of dirty assets. Yet private equity managers know that carbon pricing and tougher regulation of heavy emitters is politically fraught. So their absorption of quoted companies’ carbon intensive assets may continue for a while yet.

john.plender@ft.com