Why fixed income investors should consider ESG criteria

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Joshua Kendall, Head of Responsible Investment and Stewardship at Insight Investment, a BNY Mellon Investment Management firm.

It’s commonly accepted that equity holders are positioned at the front of the queue when it comes to engagement on environmental, social and governance (ESG) related issues. Fixed income issuers tend to hold back given they have limited voting power, and if the firm runs into problems, they’re going to jump the line and get paid before the stockholders. However, it may be the time to challenge this pattern, as there is an opportunity to engage effectively across investment grade, high-yield and emerging market fixed income instruments.

Let’s disrupt the acronym generators because responsible investing could be the start of a new BRIC era. This time it’s Biden, Reputation, Impact, and Climate. President Biden is focusing his priorities on everything from climate change to corporate activity, including taxes and diversity, which is helping to drive a good deal of the market activity we see in the US. Meanwhile, companies and asset owners are showing more sensitivity towards reputational management, viewing non-financial objectives in much the same light as meeting financial goals. There is also a growing awareness of, and interest in, impact investing. And, of course, climate change is becoming increasingly important across political and corporate agendas as public knowledge increases.

An integral part of the analytical process
In terms of fixed income, engagement means different things to different investors. Many still prioritize financial returns and look at ESG factors purely through a risk lens. Adopting such a focus can result in inconsistencies across strategies and regions. My opinion is that ESG is a vital part of the credit analysis of both corporate and sovereign bodies.

Many of the third-party ESG agencies providing assessments will work primarily on evaluating equity holdings. The process is less straightforward for debt issuance, given a company’s bond structures mean that it will usually issue multiple types of securities. As such, it’s essential to map data across each of them.

It is here that technology can help, because appraising ESG information demands more than simply tagging a new process onto existing analytical structures. With this in mind, and given the challenges presented by fixed income and its relationship with ESG issues, our team has developed a range of proprietary models. These include a corporate ESG risk consideration, where we incorporate millions of data points to help study and score a company. This matters because we take a different view from traditional off-the-shelf ESG ratings agencies on what drives credit markets.

At this point, it’s worth noting that ESG focus can be biased towards corporate bonds. However, we believe that ESG factors also apply to sovereign issuers. This is another area where we have developed in-house ratings to consider strengths and weaknesses, guiding how our team allocates to the various strategies. In addition, the growth we see in impact bonds means they also require a bespoke research process.

ESG factors with corporate bonds
As I mentioned, there is more of an established process in corporate bonds that I would describe as a ‘traditional’ ESG risk-rating approach, which looks at factors that can harm credit performance. Alongside that, we evaluate how a company is exposed to, and manages, climate risks – including both physical risks and the risks arising from a transition to a low-carbon economy. This involves assessing a range of issues from leadership, reporting, and emissions performance in the supply chain, to the impact of natural events, such as floods, heatwaves, and hurricanes. All the information we gather is aggregated in ways that help identify companies that take climate risk seriously.

The various levels of risk
If we look at different sectors, financials tend to have the lowest climate-related risk, given the increasingly electronic nature of their day-to-day business. Communication companies are in a similar position. By contrast, there are challenges with sectors, such as utilities and energy producers, whose operations can potentially have a more significant impact on the environment.

Within these riskier areas, it’s essential to identify enterprises that are taking climate issues seriously. That is what a climate-risk model does. And when it comes to measuring and addressing risk levels, engagement is fundamental. In our view, it is a myth that liaising with a fixed income issuer is problematic, as we have shown. Throughout 2020, our team had conversations with around 1200 issuers and around 90% of these discussions included at least one aspect of ESG.

Sustainable opportunities in fixed income
We will no doubt see a range of issues and concepts come to the fore over the next few years. These include impact bonds, which we believe will form a more significant part of the fixed income market in the near future. Our thought process at present is deciding how they can fit into a carefully constructed group of holdings. Another consideration is the concept of being ‘best in class’. Seeking out issuers with this kind of mentality may help to deliver a strategy that manages priorities.

Companies that are sensitive to sustainability issues should inevitably be better managers of reputational issues and key metrics. With this in mind, transparency and disclosure are critical because these elements are crucial to making informed investment decisions.

In summary, we believe there are significant opportunities in fixed income for those who are attuned to impact or reputation. Indeed, it is my opinion that there may be more possibilities in fixed income than equities, there are certainly many different ways to invest responsibly in this asset class. The glue that binds these elements together is transparency, which we believe to be fundamental to responsible investment.

DEFINTIONS

Impact investing: this refers to an investment strategy that aims to generate a specific social or environmental benefit in addition to financial gains.

All investments involve risk including loss of principal. Certain investments involve greater or unique risks that should be considered along with the objectives, fees, and expenses before investing.

Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.

This material has been provided for informational purposes only and should not be construed as investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Investment advisory services in North America are provided by Insight North America LLC, a registered investment adviser and regulated by the U.S. Securities and Exchange Commission (SEC). Insight North America LLC is associated with other global investment managers that also (individually and collectively) use the corporate brand Insight Investment and may be referred to as “Insight”or “Insight Investment”.

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