Fixed income: Will it be E, S or G?
The three components of ESG investing in fixed income – environmental, social and governance – cannot be maximised simultaneously. Investors must decide which to emphasise
• Many investors prefer to integrate ESG into their mainstream fixed income investing
• Investing only in issuers with the best scores reduces yields, although risk-adjusted returns are good
• Many prefer to boost returns and impact by investing in issuers with improving ESG as well as those with already good ESG
• Assessing and monitoring ESG for privately placed loans can be hard, but initial lenders can mitigate this through loan documentation
Deciding to apply ESG principles to fixed income investment is arguably the easy part. The hard part is to decide precisely how. Probably the first question is to decide what to prioritise. In broad terms, an investor can plump for the environmental, social or governance considerations.
The growth of green bonds shows that many investors are particularly concerned with environmental issues, but many also see a particular need to worry about governance for reasons that have nothing to do with ethical considerations.
“Whether the ‘E’ and the ‘S’ are actually material for investment-grade credit in the short-term is an open question,” says Kate Hollis, investment director at Willis Towers Watson in London. “I can’t think of a senior bond from an investment-grade company where people did not get their money back after an ‘E’ or ‘S’ failure,” she explains – pointing to the cases of the Exxon Valdez tanker spillage, or the BP spillage in the Gulf of Mexico. “But if you have a ‘G’ failure, where there is fraud and the company collapses and defaults, everybody gets hit.”
Duncan Sankey of Cheyne Capital, portfolio director and head of credit research at alternative asset manager Cheyne Capital in London, says: “Investors are starting to look at things like the carbon footprint of bond issuers, but we contend that before you get to that point, you should be focused on management and governance, because they’re the driver in any credit analysis for protecting the very high ex-ante return you get for investment-grade credit.”
In theory, the different priorities placed by different investors on the different components of the ESG alphabet do not matter. Why can’t investors care about all three? As Mervyn Tang, head of fixed income ESG research at MSCI in Hong Kong, acknowledges: “Those three objectives are separate. They can sometimes be correlated, but if you maximise one you can’t necessarily maximise the others.” MSCI has separate products to satisfy each of the three criteria, as well as indices that include all three.
There are, however, plenty of other potential obstacles. One is the risk of tracking error, relative to non-ESG fixed income indices. Another is a downside to what is actually a strength of bond issuers that score highly in ESG: their good ESG makes them less risky than other bonds. Research by Swiss Re, a fan of ESG investing, shows that this increases the average credit rating and therefore makes the option-adjusted spread – the spread between a fixed income security rate and the risk-free rate of return – lower than for typical conventional bond indices.
Tang of MSCI acknowledges that there is quite a lot of tracking error if investors use MSCI indices that exclude companies altogether if they score very low in the index provider’s ESG ratings. However, he notes that even being slightly less fussy about which companies one excludes reduces tracking error. Another compromise is to use an index that tilts the weights of each issuer based on ESG ratings, but without excluding any issuer altogether.
A further solution is to learn to love tracking error: “You can argue that good tracking error is not necessarily a bad thing,” says Tang, who refers to research from Swiss Re showing that even though the starting yield is slightly lower for ESG indices relative to their benchmarks, volatility is lower. This makes the information ratio of well-designed ESG indices – return for a given level of risk – higher.
One approach is to opt for an active strategy that gives portfolio managers the freedom to invest in countries with worse ESG, if they are attractive enough as investment plays, provided that the overall ESG score of the portfolio is high. This is the approach followed, for example, by Vontobel Asset Management, which assigns weightings to each country for its ESG emerging market local currency portfolio, based both on current practice and on signs of improvement, which increases the weighting, and signs of decline, which reduces the weighting. If done well, this can also reduce exposure to worsening credit quality.
Thierry Larose, a Vontobel portfolio manager, gives the example of Turkey, whose president, Recep Tayyip Erdoğan, has become increasingly less market-friendly since he came to power in 2003. This includes a reduction in the independence of the central bank – a black mark for its governance.
Yet another approach is not to bother about ESG indices and benchmarks at all, but instead to apply ESG to fixed income investments in general – known as integration. “We believe that ESG indices have a role to play, but we note the relatively slow flow of funds into ESG-labelled strategies,” says David Todd, head of global investment-grade credit research at Invesco in London. “The feedback that we have been getting from our clients is that they are more interested in understanding how ESG factors are integrated into an asset manager’s investment process.”
The idea of backing issuers that are improving their ESG has two virtues. One is that, if done well, it increases impact, by encouraging companies with bad ESG to redress this. Another is that it allows investors to take advantage of yield compression, as an issuer improves its ESG and therefore its creditworthiness.
This mentality is explained by Sevinc Acar, senior investment manager in fixed income at PGGM, the €250bn Dutch pension provider, who describes ESG as “one of the more important elements in our risk analysis”.
She explains: “The problem with positive screening” – only picking the best ESG performers – “is that you end up with all the good ESG quality corporates, which means that you don’t get enough compensation, so we also focus on companies that have low ESG scores but which are prepared to improve. If the company wants to improve its ESG you can make money off that.”