Bonds have historically lagged equities in the ESG field. Alex Rolandi finds out what the main challenges are for bondholders and how they aim to overcome them.
Environmental, social and governance (ESG) implementation has been on the rise in the fixed income universe over the past five years, according to Morningstar. But despite increasing popularity, fixed income ESG significantly lags equities. Sustainable investments accounted for $1.8 trillion (€1.6 trillion) of assets this year – but fixed income strategies made up only a fifth of that.
Only 26% of professional fixed income investors have a clearly defined responsible investment approach, compared to nearly 50% for equities, as bondholders struggle to exert a positive influence over companies, according to a report by NN Investment Partners (NN IP).
A common misconception is that bondholders cannot engage with companies because they lack the voting rights enjoyed by shareholders. But Edith Siermann, NN IP’s head of fixed income and responsible investing, says engagement is a necessary tool for driving sustainable change and identifying attractive investment opportunities.
“Regardless of asset class, investors have the capacity for effective dialogue with the companies in which they invest,” she says.
“In fact, companies are often particularly interested in hearing from bondholders because they have a different perspective from shareholders, especially when it comes to risk factors, and they can provide a new angle.”
Leslie Sita, portfolio manager and product specialist in Lombard Odier’s fixed income team, says: “While the concept of stewardship is typically associated with equity investments, we believe it is equally relevant for bondholders, especially for corporate bonds.”
The characteristics of corporate credit lend themselves well to stewardship, according to Sita. Bondholders can engage with companies on different issues.
She argues that sustainable investing is even more important for fixed income investors, particularly in the context of identifying downside risk, as a bondholder’s primary objective is to get back the initial investment on a future maturity date.
“Although the green bond market has been an important catalyst to address sustainability in fixed income investments, we believe there is more that can be achieved by applying environmental, social and governance factors to traditional bonds,” she says.
Dialogue is crucial to assessing creditworthiness as it improves the understanding of an issuer’s risk profile.
“Because of this focus, key areas of bondholder interest might include leverage, liquidity and tail risks – such concerns become exponentially more significant for lower-rated issuers,” says Sita.
A fixed income investor operating in an ESG framework might consider how durable a business model is amid long-term structural trends.
Sita believes companies should review their business models in the context of five structural megatrends that will play out over time: demographics, climate change, natural resources, digital revolution and inequality.
“Recent prominent cases such as the bankruptcy of PG&E in the US and Thomas Cook in the UK may have been avoided if management had identified the long-term threat – climate change and digital revolution – earlier and adjusted the business model accordingly,” says Sita.
Early engagement
Engagement might begin at the earlier stages during bond offerings. Investors want to ensure that ESG efforts and programmes in place are not only sustainable, but also prepared for future negative externalities, according to Kevin Kwok, vice-president, fixed income and ESG research at MSCI.
“Fixed income investors are also engaging more and more with private issuers where disclosures were not necessarily required. Industry associations are a great platform to voice the needs of ESG, and companies are definitely listening,” he says.
“As mandates become more focused on ESG integration across all asset classes, we have seen momentum in assessing municipals, structured finance and even highly liquid low-risk assets like commercial paper, repos, treasury bills and more.”
Incorporating ESG factors into a fixed income portfolio is a multi-faceted challenge, says Kwok. The primary issue is assessing financial materiality in different levels of maturities. “Key environmental issues such as toxic emission and waste management may have a shorter time horizon and be hit with fees and liabilities in the near-term,” he says.
“On the other hand, carbon emissions may have high contributions to externalities, but may take more than ten years to materialise. Historically, investment-grade issuers have been more transparent like public equities.”
Another challenging task is classifying the time horizons related to risks or opportunities. As opinions differ among bonds investors, mapping the level of contribution to environmental or social impacts against the expected timeframe for risks or opportunities to materialise has helped generate alpha, Kwok says.
But corporate governance is a key issue – bondholders want to get repaid as promised, after all, and fixed income investors are exposed to the same ESG risks as shareholders. These could be bribery scandals, litigation, environmental regulation or accounting scams.
“Bondholders tend to favour a reinvestment strategy to strengthen a company’s ongoing ability to repay creditors, whereas a shareholder may be interested in maximising short-term share value through dividends, buybacks or even more aggressive options,” says Kwok.
Negative environmental and social issues can materialise over time but take longer to show than problems with governance, agrees Scott Freedman, fixed income portfolio manager at Newton Investment Management (Newton IM).
“Inherently, bond investors are a bit more risk-averse – it takes a long time to recover from any negative drawdown,” he says. “Incorporating ESG factors helps create opportunities and has a material impact on credit quality. You’re forcing opportunities as well, and instigating disruption in sectors.”
According to Freedman, Newton IM’s fixed income and active teams often liaise with companies and analyse capital structures from a growth perspective. Working with their equity colleagues, the fixed income team may also get facetime with chief executives or chief financial officers.
Meanwhile, various factors can give bond investors more traction when dealing with firms. “The higher-risk the company, the lower its credit rating. Or, if the company is private rather than public, where they’re much more reliant on the debt capital markets to fund their growth – they need us,” says Freedman.
“Companies are having to get quickly used to being able to answer many more questions around ESG, and certainly around governance structures in private companies.”
Not all companies are ready for this, however. “It doesn’t mean we’ll never invest in them, but you’ve got to price these things in,” Freedman adds.
Lack of data
Government bonds make up much of the fixed income universe, which poses a problem for bondholders, as ESG factors for countries are less developed than for corporates. ESG data on countries is often outdated, says NN IP’s Siermann. Improved data usage can lead to a better risk-return profile in investment portfolios and ultimately contribute to a more sustainable financial system.
Like Siermann, MSCI’s Kwok believes there is the need for better information. In high yield and emerging markets, he says, the proportion of small-cap and private companies is higher. Often regulations are more lax and disclosures are at a bare minimum, so analysts must rely on the bond prospectus and alternative data to fill any gaps.
Understanding that key issues differ from industry to industry is also crucial, says Kwok. “We identify about six to ten key ESG issues where companies in that industry currently generate large environmental or social externalities; these are issues where some companies may be forced to internalise unanticipated costs associated with those externalities in the future.”
Asked if asset managers need to do more to implement ESG across their fixed income portfolios, NN IP’s Siermann replies with a succinct affirmative. They owe it to both society as a whole, and to their clients.
“There is growing evidence that sustainable policies will lead to stronger value creation in the long run. For example, energy providers that adapt to focus on new forms of power generation will be better placed to thrive following the transition to green energy sources,” she says.
“Moreover, in the context of global markets, it can incentivise companies and governments to allocate capital more sustainably. The growth of sustainability-focused funds over the past decades means that more capital than ever is invested in the creation of a more sustainable society.”
It takes two
The key to integrating ESG criteria in fixed income is twofold, says Morningstar’s associate director of passive strategies research, Jose Garcia Zarate. An investor needs to have a well-defined set of ESG principles and information about companies to assess whether their profile aligns with those principles. “Basically, it takes two to tango,” he says.
“Applying ESG criteria to governments is a bit of a minefield, as there is always a very fine line between making an objective ESG assessment and straddling into political territory, which large asset managers and rating companies typically wish to avoid,” he says.
Taking a stand against the policies of an elected government might be something that an individual investor might find easy, but a large asset manager could be accused of interfering with a political process.
“This is why ESG analysis and integration for government bonds tends to rely on more basic macroeconomic indicators. This may not please all end-investors, but at the moment it is what it is.”
As bond investors do not have shareholder rights, they have a stronger duty to engage with companies in order to advise and influence behaviour, Garcia Zarate believes.
“Bond investors do that regularly, while small bondholders are free to join forces with shareholder activist groups to create critical mass,” he says.
This is something Newton IM’s Freedman also suggests. To gain more clout over companies, smaller bondholders can form quasi-coalitions to exert influence over behaviour.
If all else fails, fixed income investors have one last trick up their sleeve. They may not be able to vote, says Garcia Zarate, but they always have the ultimate weapon – divesting.
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