Why schemes should think about ESG in fixed income portfolios
Environmental, social and governance factors aren’t just for equity investors
Trustees are getting used to the idea that environmental, social and governance factors (ESG) can have a material impact on the performance of their investments. But most of the work on ESG integration has so far happened in the equity space. Less research has been done into the impact of sustainability on fixed income returns.
But this is a developing sector and there is a growing body of evidence that investors should consider integrating ESG factors into their fixed income portfolio. There is also a fast expanding range of tools and strategies to help them do so.
While there are some challenges, it is a very exciting time to be part of this growing field
JP Morgan Asset Management executive director Peter Kocubinski says: “While there are some challenges, it is a very exciting time to be part of this growing field, because our clients are increasingly looking for solutions and there’s plenty of room to move the industry in a productive direction.”
Kocubinski believes it is too early to make a definitive statement on whether factoring in ESG risk has a positive impact on performance – a few more years of data are needed before that claim can be made.
But he makes the argument that ESG risk factors that can hit earnings in companies and potentially cause a bankruptcy. “So those are things we care about alongside non-ESG risks when looking at an issuer,” he says.
Studies carried out by Oekom Research – a rating agency that specialises in sustainability factors – backs up this idea. Jaspreet Duhra, UK senior client relations manager at the firm, says this research has addressed the downside risk – limiting the chances of default. Studies on the equity side have focused more on the chances of firms with high ESG ratings outperforming.
We wanted to see if companies that we identified as having strong sustainability scores were deemed to be less risky by the market
“We wanted to see if the companies that we identified as having strong sustainability scores were more likely to repay their interest and capital and were deemed to be less risky by the market,” she says.
The firm gives each issuer a grade from A+ to D-, with around 16% accorded ‘prime status’. When it checked its prime companies against a number of non-ESG financial factors, it found they were also less risky. They were less highly leveraged, and therefore more likely to repay their debts, and had a lower credit spread, meaning they were judged by the markets to be safer investments than their peers.
Oekom also provided data on its ESG ratings of sovereign debt issuers to Henley Business School for a study that found a correlation between prime countries and those least likely to default. “Anecdotally if you look at Greece, we’d given them a poor sustainability rating while the mainstream rating agencies were still putting them in the A range,” adds Duhra.
What to measure?
The ESG factors that will be relevant will vary from sector to sector. In some industries the biggest risks are obvious: for energy firms and utilities, climate change and environmental risk are near the top of the list, whereas for retailers, questions about labour practices, supply chains and customer engagement are potentially more pressing.
In other spaces such as securitised debt, governance factors could be very material
“In other spaces such as securitised debt, governance factors could be very material, such as the ownership structure of an issuer or whether lending practices are appropriate,” says Kocubinski.
Oekom measures around 700 hundred factors across 50 sectors. For each sector it chooses around 100 that are relevant and four or five that are particularly significant, which it weights more heavily. For countries it looks at 100 indicators. “As well as inputs we look at outputs, so if we say they have a high expenditure on education as a percentage of GDP we want to see how that translates into outputs such as the pupil teacher ratio in primary schools and the standards of key skills attained by 15-year-old pupils,” says Duhra.
Engage or disengage
Once investors have identified the best and worst performing issuers they are faced with the question of what to do with this data. Do they use it to screen the market positively or negatively, or do they engage with companies and countries that could be doing better?
We are excluding the worst, but are not necessarily excluding the close-to-worst
“The philosophical question is to what extent do you attach a certain risk premium to certain types of operation and to what extent you exclude names,” says Neuberger Berman co-head of emerging market debt, Rob Drijkoningen. “We lean towards the former – we are excluding the worst, but are not necessarily excluding the close-to-worst because, ultimately, everything has to have its price.”
This means the firm rules out controversial arms manufacturers and countries with dismal governments like North Korea or Sudan, but not whole sectors like oil and gas.
Drijkoningen says that Scandinavian clients are also interested in using the exclusion list developed by Norges Bank Investment Management, the largest sovereign wealth fund in the world, to screen fixed income portfolios too. “So there is some transmission from equity ESG to fixed income.”
Investors could also add a positive tilt where they weight their portfolios to the highest rated firms. But when it comes to engaging with ESG laggards, though, debt investors have traditionally been seen as being in a much weaker position than equity investors. Shareholders find it easier to get the ear of the board, and have voting rights at annual general meetings.
But the bond market has plenty of clout. Issuers are so concerned about their cost of borrowing that former US President Bill Clinton’s adviser James Carville joked that he wanted to be reincarnated as the bond market: “You can intimidate everybody.”
Engagement policies are different if you’re a fixed income investor, but they’re still possible
So how do creditors throw their weight around? “Engagement policies are different if you’re a fixed income investor, but they’re still possible,” says Kocubinski. “Issuers are interested in what we want as investors and that could be just more fully articulating their sustainable practices, or it could mean specific offerings like green bonds for specific projects.”
But what really gets companies’ attention, whether you’re an equity investor or a debt investor, is the size of your holding. Duhra says: “It helps if you engage with a company pre-issuance, but if you’re an established long-term investor, they’ll want you to invest in future issuance, so you can still have a voice.”
This voice will be stronger for investors in in smaller companies, high-yield companies and non-listed companies that don’t have the access to the same pool of capital as a larger, listed corporate does.
But there are still plenty of challenges facing the ESG-minded investors in the fixed income space. Agreeing on a common vocabulary and a common set of metrics would help the sector to grow, as would improving the coverage of ESG data. There is plenty of information on investment grade corporates, but less on high-yield and emerging market issuers.
It can also be tricky to disentangle some corporate structures. “It can be difficult to understand what the ESG score is for a particular issuer, because they roll up to a parent company that has a score, but the issuer-level companies all have different ESG practices,” explains Kocubinski.
But, with ESG concerns growing in profile for UK schemes, and most shifting from equities to fixed income in the last decade, the sector is set to continue expanding. Kocubinski says: “We have seen an increase in institutional concern and questions about ESG practices for their managers, and we think this will continue to grow.”