Goldman's' Call On ESG Debt Paved The Way For A Hedge Fund's Big Short

An investment strategy employed by a hedge fund is already capitalizing on the new price realities as experts at Goldman Sachs Group Inc. declare the so-called geranium to be dead.

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Beginning in 2023, credit strategists at Goldman Sachs declared that the long-standing premium on debt aimed at achieving environmental, social, and governance goals was a thing of the past. According to Gopi Karunakaran, co-chief investment officer at Sydney's Ardea Investment Management, their announcement, which was only applicable at the moment of issue, also affected secondary markets and presented investors with a unique opportunity.

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Karunakaran is taking advantage of the opportunity to short traditional bonds and buy their green counterparts. Despite the tiny price differences, if the bets are large enough, gains might be significant. In an interview, he claimed, "You really couldn't do it before 2022 because every green bond was pricey. "Right now, the market is becoming considerably more price-tense."

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According to Karunakaran, the absence of a price premium for ESG bonds makes sense right now, given how badly all bonds have been affected by rising interest rates and liquidity issues. Also, ESG issuers must contend with a more challenging regulatory and political climate as well as pickier investors. Nonetheless, he predicts that the price flatness will soon turn around.

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He said that some of the structural expensiveness of green bonds had vanished. Longer term, however, all signs point to the current "mispricing" finally "normalizing," he claimed.

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There is inconsistent research on the so-called geranium. For instance, a recent analysis by the Climate Bonds Initiative, an international group whose declared mission is to direct more funding into climate-friendly projects, revealed that it is still less expensive for issuers to seek finance through ESG debt markets. According to Trade Algo research published in December, the 'geranium' reached its height in 2020 before turning around in 2022.

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According to Michael Puempel and Lotfi Karoui, analysts at Goldman Sachs, there is no longer a difference in funding costs between conventional debt and bonds with ESG objectives when taking into account variables like industry, rating, and term together with the macroeconomic background over time.

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Karunakaran specializes in determining the relative value that arises when prices for two extremely similar assets diverge, which he claims is now the case with conventional and ESG bonds. He has had success with this strategy in the past. According to Karunakaran's relative-value study, Ardea was investing heavily in inflation-linked bonds in 2020, when other market players thought the possibility of rising prices was still remote.

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The chances to profit from major RV dislocations that happen during times of increased market volatility or stress are of special interest to us, he added. There can be "pronounced differences in price across identical bonds" as a result of forced trading, stop-losses, risk aversion, and other related occurrences.

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Ardea is a member of a group of specialized bond funds that frequently includes former employees of Wall Street proprietary trading desks. Firms like Ardea are pouncing on minute price disparities, which may provide outsized profits if the wagers placed are large enough. Stricter restrictions put in place after the 2008 financial crisis prevent banks from taking the amount of risk required for such transactions to be relevant.

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For relative-value experts, the case study of green debt is appealing. Consider the usual "twin" of German green bonds, which has the same coupon and maturity. Two securities are produced with the same credit and duration risk. Nonetheless, the two regularly differ in price, providing a pure-play wager on liquidity and ESG asset demand.

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Karunakaran says 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. 

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Certain debt markets are more affected than others, according to Karunakaran. One of these is the UK, where a fall in bond prices at the end of last year brought on by the budget plan of the then-prime minister Liz Truss has left deep wounds.

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He stated, "Gilt is a fantastic market where you've got some green bonds that have ended up selling pretty low on the curve due to the volatility of liability-driven investments. "So what we'll do is come in, purchase those specific green bonds, and then we'll take a short position against that through swaps or futures because we don't want to simply have broad gilt market exposure," the author continues.

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According to him, Ardea "has no perspective" on gilt rates, inflation, or the overall macroeconomic situation in the UK. Karunakaran claims that he is wagering on a 2033 UK green bond as opposed to comparable non-ESG gilts.

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Karunakaran's relative-value methodology "has been expressly built to produce alpha from" locating and trading on these mispricings, he added. We predict that as green bond markets develop, these possibilities will structurally grow over time.

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