While corporates increasingly have to turn to capital markets for funding, now is the time for investors to push their ESG requirements, writes Joshua Hughes

Fixed income as an asset class has yet to experience the same growth in demand or availability of socially responsible investing (SRI) strategies and environmental, social and governance (ESG) options as in equities.

The options for fixed income investors have traditionally been limited to government securities, investment grade debt and the more niche areas of micro-loans and community lending.

From an ethical standpoint, this is clearly a dilemma for individuals or institutions that have ESG principles high on their agenda, for some of whom ESG investing is not just choice but a regulatory imperative. They have faced a stark choice between avoiding sections of the fixed income market where ESG solutions are scarce - high-yield for instance - and missing out on potential returns and diversification, or putting aside their principles.

But fixed income is beginning to catch up. Investors are increasingly calling for SRI/ESG principles to be applied across a wider range of fixed-income assets. As demand has grown, so too has the breadth of fixed-income ESG solutions. The benefits and attractions of applying SRI principles more broadly across the fixed-income universe are considerable.

Diversification is a very important consideration - SRI investors should be able to spread their portfolio in a sophisticated allocation as they can in conventional, non-ESG holdings. By being restricted to sections of fixed income, investors may be exposed to greater concentration risk than is desirable, leading to high portfolio correlation and potentially lower returns.

Another attraction of being able to widely invest in SRI strategies across asset classes and their sub-sectors is that it allows socially responsible investors a greater opportunity to effect change in the world around them.

Shareholder activism is traditionally seen as the best way for investors to have a say in how companies are run - by proposing motions and voting in areas such as board of director membership, directors’ pay and so on. This can be very effective but it would be a mistake to underestimate the power of debt to facilitate equally important changes in corporate behaviour.

The fixed-income universe is typically much larger than that of equities and can therefore be seen to offer greater opportunities to influence companies’ behaviour. In 2009 the US credit market was three times the size of the total US equity market, and the average debt-to-equity ratio for companies in the S&P 500 is 1.39. ESG investors interested in making an impact with their money should not ignore the opportunity this creates.

And it is not just among corporations that these opportunities exist. There are government bonds and issuance from the wider public sector, local government, infrastructure projects and more. This means a tremendous scope for debt investors to not only reward entities that meet their ESG standards with funding, but also to insist on changes in those that do not meet them - under threat of withholding financing if necessary.

By investing in an entity aligned with ESG values, investors can lower its cost of borrowing and potentially increase profitability. By not investing, a large institution may be able to raise the cost of funding or cut off finance for companies unaligned to ESG principles. In fact, the 2010 Moskowitz Prize for scholarly research of SRI strategies went to ‘Corporate Environmental Management and Credit Risk’, by Rob Bauer and Daniel Hann, who demonstrated a direct negative correlation between environmental track records and funding costs. Companies with poor environmental track records have been lower rated and have had to pay more to borrow historically. Furthermore, this correlation has strengthened in recent years.

Any increased cost of borrowing - or not being able to borrow at all - will make a company less profitable and might encourage it to consider aligning with an ESG agenda because it will ultimately help their bottom line.

The retrenchment of bank lending in the wake of the financial crisis and credit crunch has handed further power to debt investors in this respect. More companies are turning to capital markets to finance their growth plans. This means debt investors are now more than ever in a strong position to insist on, for instance, certain performance targets being met, or to demand pre-agreed limitations on the activities of their investments.

In the sub-investment grade and high yield space, the influence of debt investors can be especially strong because high-yield lenders, in particular, have better access to company managements. Such businesses tend to keenly recognise the importance of maintaining good relations with their lenders because their higher risk status could otherwise make it difficult for them to obtain funding. By maintaining an open and transparent dialogue, high-yield companies can better ensure their company’s future financing, often at more attractive rates and terms.

In exchange, high-yield debt investors are given the opportunity to ask that certain ethical standards are considered and put pressure on companies to include commitments to them in official documents, statements and disclosures.

So what constitutes an ESG or SRI investment? Much like beauty being in the eye of the beholder, so ethics and principles are in the minds of investors. Sovereign wealth funds in Islamic countries - in part responsible for some of the growth of fixed income ESG investing - will find certain investments acceptable that a Swedish pension fund might not, for instance.

Whatever the requirements, much like with equities, debt can be positively or negatively screened in line with the needs of an investor. There are also established methodologies such the UN Global Compacts Principles. This focuses on ethical standards around employment, human rights, the environment and corporate responsibility.

Specific ESG performance analysis can also be used to identify the best ESG performers among their peers. This more sophisticated approach will highlight companies that can demonstrate that their processes and practices are sustainable.Arguably those companies that can demonstrate sustainability may be more likely to prosper over the long term and less likely to default.

This system can also help expose companies with bad governance, which has been at the heart of some of the most spectacular defaults of recent times.

It should not be forgotten, though, that ultimately investing in all its forms is about getting a return on your money. It is no good investing in a company that ticks ESG boxes but cannot repay its debt. Companies must be assessed using a rigorous and fundamental credit research process. Investments that have the right risk/reward profile can then be ESG screened and selected or discarded on that basis.

In summary, the application of ESG principles across the fixed-income spectrum is growing and has the potential to be equally, if not more, effective as equity investments in bringing about change in the way companies, governments, public sector institutions and other entities are run. As this happens, so more companies will realise the rewards of improving ESG standards and commit to doing so, completing a so-called ‘virtuous circle’ that will benefit their financial position and therefore their investors too.

Joshua Hughes is head of sales and marketing for Muzinich & Co UK