Shorter-duration government bonds could face “sizeable” yield shocks under more orderly climate transition scenarios, MSCI has warned.
In a research paper, How Climate Transition Risk May Impact Sovereign Bond Yields, MSCI said US five-year yields risk rising by 100 basis points under Net-Zero 2050, whereas more disorderly scenarios such as Divergent Net Zero would create shocks towards the back end of the curve.
“Transition risk is not just applicable to longer-dated bonds. Our results caution against downplaying transition risk as a distant issue relevant only for longer-dated portfolios,” Bhaveer Shah, the paper’s author and vice president for ESG research at MSCI, said.
“Even if this holds some merit under delayed-action scenarios, front-end sovereign exposures might be affected heavily if countries were to step up mitigation efforts faster than anticipated under the delayed scenarios.”
The research model used inputs from the Network for Greening the Financial System (NGFS) and the National Institute Global Economic Model (NIGEM) to assess how differing transition scenarios could affect macroeconomic variables such as gross domestic product (GDP), inflation and interest rates.
At a country level, China and the US will see the biggest shocks to their five-year yield curves under Net Zero 2050, both of which will rise by almost 100bps with Singapore, Hong Kong and Vietnam would be equally affected.
The UK could expect a 50bps rise at the shorter end of the curve while Europe would fair better with a 25bps rise.
Conversely, a Divergent Net Zero scenario would see 20-year government bond yields badly impacted with rises of roughly 75bps across the UK, US, China and Europe.
Shah added country-specific dynamics also require attention, with yield impact risks varying between countries with similar climate profiles including emission levels, economic development and geography.
“Yield increases are not solely driven by the size of the decarbonization journey; what matters too is how quickly that change influences macroeconomic variables, such as inflation, within that country,” he said.
For example, the paper said Sweden, a country with a “greener” reputation and lower current per capita emissions compared to the US could still see shocks of 100bps in certain scenarios.
The research paper also analysed the impact transition risk would impact GDP.
The effect is thought to be smaller than first anticipated, and in some countries positive, although delayed scenarios would lead to a greater hit to GDP. Furthermore, the downside risk is thought to be higher for emerging markets.
“Even under some of the more stringent climate scenarios, NGFS/NIGEM models often indicate less than a 5% cumulative change in the level of GDP over the next 30 years from transition risk, compared with the baseline,” Shah said. “This implies it may be possible for economies to decarbonise without inflicting heavy downside risks to growth.”
The report added sovereign bonds could be impacted by “greenflation”, noting that decarbonisation may lead to a persistently higher drift in persistent inflation.
“In some scenarios, decarbonisation is a decade-long “sticky” phenomenon. This matters, as some monetary policymakers might see the persistence of greenflation as a reason for higher interest rates,” Shah said.
“To better navigate an inflationary environment, sovereign bondholders thus might need to be attentive to the underlying cause of inflation, and not just the modelled yield shock.”
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