Lothian Pension Fund has awarded a corporate bond mandate to Royal London Asset Management (RLAM) after placing greater emphasis on climate risk-related requirements for its strategy.
The move is linked to a decision to explore topping up the £10.3bn (€11.8bn) Scottish pension fund’s credit exposure. In response to the shrinking premium corporate bonds offered over government debt in recent years the pension fund had increased its tactical allocation to sovereign bonds – mainly Gilts – and reduced its allocation to corporate bonds – dropping its then manager, Baillie Gifford.
“We still think the sector is expensive, but we tend to be a little contrarian and so we started to say it’s time to put in place a new corporate bond mandate in order for us to have the means to build up a position when market conditions are more attractive,” said Gillian de Candole, head of responsible investment for the local government pension scheme (LGPS) fund.
“In addition, when we’re looking at new managers we can seek strong alignment with our statement of responsible investment principles.”
Adopted in 2020, these principles set out the fund’s approach to integrating environmental, social and governance issues (ESG), including climate change.
Lothian’s mantra to ‘deny debt, engage equity’, reflects the distinction the pension fund makes between secondary investment – the trading of equities – and primary investment – subscribing to new bonds and new equity.
“While we aim to influence companies to commit to align with the goals of the Paris Agreement, we also avoid subscribing to new equity and fixed income issuance from companies whose business plans we assess as incompatible with the aims of the Paris Agreement, because we recognise that new issuance – particularly of debt – finances new production capacity,” said de Candole.
RLAM ‘stands out’
Fast forward to late 2024, and Lothian began the search for a manager that could help it implement that mantra in credit.
“We didn’t just want ESG integration,” de Candole told IPE. “We wanted a manager who could show us they’re really looking at climate risks in an appropriate way, potentially climate opportunities as well.”
She added: “We wanted the strategy to have a high active content, so it has quite a lot of exposure to secured credits as well, and there’s not necessarily a lot of data on a big proportion of the portfolio, so we’re very reliant on having a manager that we trust is doing the analysis across all the risks.
“When we got down to our shortlist, it was RLAM that really stood out, because they already had a framework in place that they were using internally and starting to develop for client products. Other managers talked about doing this, but they didn’t necessarily have a framework they could articulate as clearly as Royal London.”
This framework sees RLAM assign ‘alignment conviction’ scores to issuers based on a combination of comprehensive transition analysis, engagement and third-party data.
“At the initial stages we were really interested in having minimal exposure to high risk issuers”
Gillian de Candole, head of responsible investment for Lothian Pension Fund
The asset manager gives primacy to its own climate analysis, having spent the past five years developing an in-house emissions database to deal with problems such as a structural data coverage issue for fixed income, exacerbated by issuer and subsidiary mis-mapping.
There wasn’t an off-the-shelf product that met all of Lothian’s requirements, however, so the LGPS fund worked with RLAM to develop customised ESG rules as part of the mandate.
The result is an actively managed, mainly sterling, pooled fund with rules such as a cap on the financing of issuers deemed “incompatible” that ratchets up over time.
De Candole explained that Lothian spent a good amount of time with RLAM discussing the initial portfolio construction and refining the ESG rules to avoid constraining the expected financial performance of the portfolio.
“While our climate alignment concern is focused on new issuance, when you’re building up a new portfolio, you’re going to have some secondary trades, as well as considering new issuance in that period. RLAM went beyond our expectations to agree an exposure limit on incompatible issuers from the start of the mandate,” she said.
“Over time, you would expect to see climate metrics improve as progress is made in the world, but at the initial stages, we were really interested in having minimal exposure to high-risk issuers. The limit tightens after a number of years because these companies will come back to finance, and the risks are greater at that point if their alignment hasn’t improved.”
Forward-looking
Lothian made an initial allocation of £40m to the mandate last summer, which boosted its credit allocation to 3% of total fund assets.
Noteworthy is also that Lothian structured the mandate so it could work for its collaborative partners, neighbouring LGPS funds Falkirk and Fife.
For several years, the three funds have had a collaborative investment model and joint investment forum using Lothian’s in-house investment team and its FCA-regulated permissions to provide investment advisory services to other LGPS funds.
“This is the first external asset manager that all three collaborative partners have allocated to,” said de Candole.
Fixed income has lagged public equities when it comes to the integration of climate considerations, and de Candole is on the lookout for new trends to catch on in credit.
“On the equity side, we’re seeing a big push from shareholders asking about capital expenditure, but actually it’s the corporate bonds financing the capital expenditure, so I’m hopeful that we’re going to see a coming together of those two streams in the responsible investment world.
“That way it’s not all just about green bonds or sustainability-linked bonds – general financing from unlabelled bonds is a much larger part of the market.”
