Mar 19, 2023
Goldman Call on ESG Debt Paves Way for a Hedge Fund’s Big Short
As analysts at Goldman Sachs Group Inc. call time on the so-called greenium, one bond fund’s strategy is already taking advantage of the new pricing reality.
Credit strategists at Goldman Sachs started 2023 by declaring that the long-standing premium on debt targeting environmental, social and governance goals had been consigned to history. Their pronouncement, limited to the point of issuance, also carried over to secondary markets, creating a rare opportunity for investors, according to Gopi Karunakaran, co-chief investment officer at Ardea Investment Management in Sydney.
Karunakaran is seizing the moment to short conventional bonds and go long their green equivalents. The price differentials are small, but if the bets are big enough, profits can be considerable. “You couldn’t really do that pre-2022 because every green bond was expensive,” he said in an interview. “Now you’re seeing much more pricing tension coming into the market.”
Karunakaran said the absence of a price premium for ESG bonds makes sense here and now, after bonds across the board got pummeled by higher interest rates and liquidity concerns. ESG issuers also face a much tougher regulatory and political environment, as well as more discerning investors. But that flattening out of prices will eventually reverse, he said.
“Some of that structural expensiveness of green bonds has gone away,” he said. But longer term, there’s every indication that the current “mispricing” will “normalize eventually,” he said.
Research looking into the so-called greenium isn’t always consistent. A recent study by the Climate Bonds Initiative, an international organization whose stated goal is to steer more capital toward climate-friendly projects, showed that it’s still cheaper for issuers to raise money through ESG debt markets.
Analysts at BloombergNEF reported in December that the so-called greenium peaked in 2020 before reversing in 2022. Meanwhile, M&G Investments found that the green debt of companies with lower carbon emissions trades at a significant premium to that of heavy polluters.
The Goldman analysts, Michael Puempel and Lotfi Karoui, estimated that when controlling for factors like industry, rating and maturity alongside the macro backdrop across time, there’s no longer any difference in funding costs between conventional debt and bonds linked to ESG goals.
Karunakaran specializes in identifying the relative value that gets created when prices for two very similar assets look off, which is what he says is now happening with ESG and conventional bonds. It’s an approach that’s served him well in the past. Karunakaran’s relative-value analysis meant Ardea was piling into inflation-linked bonds in 2020, when the prospect of higher prices still seemed remote to most market participants.
“Of particular interest to us are the opportunities to take advantage of extreme RV dislocations that occur during periods of heightened market volatility or stress,” he said. “Forced trading, stop-losses, risk aversion” and similar events can all “cause pronounced inconsistencies in pricing between similar bonds.”
The major sovereign-bond markets that Karunakaran trades have been gripped by a dramatic surge in volatility in recent days and weeks as three US lenders collapsed, followed by the state-brokered takeover of Credit Suisse Group AG. Some German and US bond yields recorded their largest daily swings in decades amid thin liquidity.
Ardea is part of a sub-set of specialist bond funds that tend to be made up of veterans from Wall Street proprietary trading desks. With stricter post-2008 regulations preventing banks from taking on the kind of risk needed for such trades to be meaningful, firms like Ardea are pouncing on tiny price differences, which can deliver outsized returns if the bets placed are big enough.
For relative-value wonks, green debt offers a compelling case study. Take German green bonds, which have a conventional “twin” with the same coupon and maturity. That creates two securities with identical credit and duration risk. Yet the two trade at prices that frequently diverge, offering a pure-play bet on liquidity and demand for ESG assets.
The Trussonomics Effect
Karunakaran said some debt markets are more affected than others. Among these is the UK, where a plunge in bond prices late last year triggered by the budget proposal of former Prime Minister Liz Truss has left long-lasting scars.
“Gilts is a good space where, because of the” liability-driven investment “chaos, you’ve got certain green bonds that have ended up trading relatively cheap on the curve,” he said. “And so what we’ll do is we’ll come in, we’ll buy those particular green bonds and then against that we’ll have a short position through swaps or futures, because we don’t want to have just general gilt market exposure.”
Ardea has “no view on gilt rates or inflation or whatever the macro picture in the UK” is, Karunakaran said, adding that he’s betting on a 2033 UK green bond versus similar non-ESG gilts.
Identifying and trading on these mispricings is what Karunakaran’s relative-value model “has been explicitly designed to generate alpha from,” he said. “We anticipate these opportunities will structurally increase over time as green bond markets mature.”
The global ESG bond market had its busiest February on record, driven by large deals from governments and a string of debut transactions from big corporations.
(Updates with M&G research in seventh paragraph. Earlier version of story was corrected.)
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