The ‘why and how’ of integrating biodiversity into fixed income strategies

One of the fundamental features of biodiversity is that it reaches into every part of our lives – and that means the impacts of biodiversity loss are also felt across investment strategies. Looking specifically at fixed income, we see important reasons why investors should integrate biodiversity into their decision making.

First, biodiversity loss presents risks that could impact the performance of fixed income portfolios. As with climate change, the starting point is to understand the risks in play. First, they may be physical risks from biodiversity loss and ecosystem degradation, and second, there are transition risks linked to global efforts to tackle the problem, which of course could include increasing liability risks. Lastly systemic risks such as inflationary effects which could affect entire sectors not just individual issuers.

We believe that companies which do not proactively address these risks - and which fail to adopt more sustainable nature-positive business models - could face higher costs or lower revenues, therefore reducing their ability to repay debt in the future.

Another reason why we believe fixed income investors need to act is that we can see increasing interest from asset owners who want to mitigate their negative impact on biodiversity by reducing the biodiversity footprint of their investment and financing activities as well increasing interest in as generating positive impact by investing in bonds with a direct biodiversity focus such as green or blue bonds¹ .

According to estimates from the Convention on Biological Diversity and the Intergovernmental Panel on Climate Change (IPCC), between $150bn-$440bn per year should be allocated to biodiversity solutions to reverse biodiversity loss² .

However, our view is that the private sector’s current financial flows are merely a drop in the ocean. Clearly there is more work to do here and harnessing financial markets can help plug this gap. Fixed income is such a huge asset class that it can create meaningful change to drive issuers to reduce their biodiversity footprint.

Why net zero investors need to embrace biodiversity considerations

Climate and biodiversity and social factors are inextricably linked - there is little value in pursuing improvements in one without considering the other.

• Climate change is one of the five direct drivers of biodiversity loss – limiting climate change is therefore part of the solution for biodiversity erosion mitigation
• Natural capital and nature-based solutions, such as mangroves and forestry, not only represent high biodiversity-value areas but are also perfect carbon sinks which can help offset human-made carbon emissions
• Some climate change solutions may have important biodiversity impacts and contribute to biodiversity degradation. An example of this could be the building of a new dam. While providing clean energy, it can have significant impacts on the surrounding biodiversity ecosystems

A holistic assessment of environmental risks is key for an effective transition to more sustainable economies. When integrating climate change into investments, we think that a full lifecycle and value-chain analysis should be undertaken to consider the impact on biodiversity and on social issues related to economic activities. 

Assessing portfolio risks and impacts

The extent to which fixed income investors can consider biodiversity is determined by the availability of information from which they can make credible portfolio decisions. The availability of biodiversity data isn’t perfect, and portfolio-level decisions should acknowledge this, rather than being a hurdle to starting integration.

In the fixed income universe, addressing biodiversity is more complex due to the lack of specific instruments dedicated to financing natural solutions. Therefore, we focus on managing risks to preserve asset value in the long run. At AXA IM, we:

• use the Taskforce on Nature-related Financial Disclosures³ ’ (TNFD) framework to identify high-risk sectors and
• leverage Iceberg Data Lab’s Corporate Biodiversity Footprint⁴  to mitigate risks at an individual issuer level

Integrating biodiversity into fixed income portfolios

The good news for bond investors is that it is possible to integrate biodiversity into fixed income portfolios. When it comes to our strategies, we can and do integrate biodiversity into our investment approach in multiple ways.

Across all fixed income portfolios, we can consider and mitigate biodiversity risk with exclusions and engagement as well as monitor and report on biodiversity metrics.

• Exclusions: Deforestation poses unique economic, environmental and social challenges, including biodiversity loss, increasing greenhouse gas emissions, unsustainable land use and labour issues. AXA IM does not invest in companies involved in deforestation and natural ecosystem conversion should be avoided when negative business practices are clearly identified as per our ecosystem protection and deforestation policy⁵
• Engagement: Having a constructive dialogue and actively encouraging issuers to shift their business practices to reduce their biodiversity footprint is key to fostering positive change. From a financial perspective it helps identify those ‘hotspots’ within a portfolio and structure discussions with issuers around material nature-related topics – helping them to become more aware of, and resilient to, the implications of supply chain and consumer risks from biodiversity loss. In other words, avoiding any surprises that might impair their ability to repay debt. At AXA IM we have increasingly prioritised biodiversity and nature-related engagements as part of our overall stewardship approach. Until now our engagements with companies when it comes to biodiversity have mainly been on deforestation and pollution. As that work has become relatively mature our focus is increasingly turning to water and the circular economy. In addition, we are member of Nature Action 100, as we believe in the power of collaborative engagement in this emerging topic⁶
• Biodiversity Reporting: At AXA IM, we use a metric called the Corporate Biodiversity Footprint (CBF), developed by Iceberg Data Labⁱ . It aims to estimate the negative impact on biodiversity of a company’s economic activities, across its value chain, each year. It considers the impact from different drivers (e.g. land-use change, climate change, pollution) associated with a company’s processes, products and supply chains

There are several ways fixed income investors can go a step further in their integration of biodiversity risks. A basic starting point is to tilt portfolios away from issuers with a high biodiversity footprint and little ambition to reduce it, towards companies in the same sector that have identified the risks and impacts and are reducing and monitoring them. Detailed issuer-level analysis is critical here. 

Fixed income investors may also use the lever of bond maturities - the date on which the principal amount of a bond is to be paid in full-  to mitigate biodiversity-related risks within their portfolios. For example, in regard to issuers with a high dependency on natural resources or a high biodiversity footprint, investors could opt to only invest in shorter maturities and only re-invest if the issuer has made sufficient progress and commitments in terms of mitigating risks and/or lowering its footprint.

Additionally, investing in fixed income instruments including use of proceed bonds such as blue, green and sustainable bonds with a direct link to biodiversity is one of the most common ways to integrate biodiversity into investment portfolios, as well as sustainability-linked bonds (SLB). We explain these below.

• Blue bonds

Blue bonds are bonds that directly finance marine and ocean-based projects. The International Capital Market Association (ICMA) published its blue bonds guidance for what activities can and cannot be labelled as a blue bond in 2023. This is crucial to ensure trust and consistency across labelled bonds and previous ICMA guidance was a springboard for growth in other use-of-proceeds bond markets. However, the current investible universe is very small at less than $10bn⁷  – meaning illiquidity, lack of diversification and therefore higher risk for investors. These are all things bond investors seek to avoid.

• Sustainability-linked bonds

Sustainability-linked bonds (SLB) are not use-of-proceeds bonds as the assets raised from bond sales do not get directed to specific projects but to general company expenditure. The bond comes with a specific company-level target e.g. to reduce carbon emissions by 20% over the next three years. If this doesn’t happen there is a coupon step up, typically 25-50 basis points of cost. About 75%

of SLBs are used by smaller issuers that don’t have sufficient issuance size to be index eligible (at more than $200m) but still want to highlight sustainability credentials.

• Green and sustainable bonds

Green and sustainable bonds are those which directly finance environmental projects and therefore often use part of their proceeds to finance initiatives aimed at protecting and preserving ecosystems. We currently estimate some 25% of the green bond universe is linked to biodiversity. The biodiversity allocation can vary significantly from one green bond to another and therefore they do not have the same level of biodiversity focus as blue bonds. However, the size of the green bond market is approximately $1.9trn⁸  meaning their liquidity and diversification benefits far outweigh their more diluted biodiversity focus.

Additionally, the most innovative area in the market is blended finance, which combines public and private funds to scale financing directed to developing economies. We believe that debt-for-nature swaps, which enable countries to restructure their debt in exchange for a commitment to protect and restore ecosystems, shows promise in this regard.

The road ahead

Ultimately biodiversity loss threatens lives, the planet and the global economy - more than half the world’s GDP is reliant on nature⁹ . It poses a myriad of economic risk Which could translate to tangible investment risks in fixed income portfolios.

But, thanks to the size and unique features of the asset class such as differing maturities and instrument types, fixed income investors have a major role to play in tackling biodiversity loss.

Investors can start today by –assessing portfolios against high-stakes sectors and issuers contributing to biodiversity loss, excluding XYZ, engaging individually and collaboratively and by considering investing in in sustainability-focused bonds.

In our view, this is a market which has the potential to grow. And it is a market which offers many rich opportunities that fundamentally will help the world on its complex, but vital, journey to net zero.