There are plenty of opportunities for shareholders to make their ESG views known to boards. Bondholders, however, have fewer chances, but they are applying some creativity. Lynn Strongin-Dodds reports

Socially responsible investing is often thought of as an equity play, but recently investors are delving into the fixed income realm. One of the main differences is that bondholders do not engage with companies in the same way as their equity brethren.

According to research from Muzinich & Co, a global institutional asset manager specialising in corporate credit and credit-oriented investment strategies, historically, SRI investing was focused on equities with shareholder activism the preferred route for encouraging changes in corporate behaviour. Interest in fixed income had been limited to microfinance, community-based investing and low-yielding government and investment grade bonds.

However, as Cheryl Rivkin, the firm's director of client services, points out, the credit crunch has changed the way investors think. "They are taking other factors into consideration and not just looking at the bottom line in a pure financial way," she observes. "They are also applying environment, social and governance (ESG) criteria when looking at investments across different asset classes."

The larger and more sophisticated investors in UK, Europe and the US are leading the way in the SRI fixed income arena but overall there has been a surge in ethical investing across asset classes post-financial crisis. The latest figure from the UK Investment Management Association (IMA) shows that ethical funds investments in the UK not only rose 25% to £74m (€88.6m) in Q3 2010 compared with Q3 2009, but that it was also higher than the £64m average over the previous four quarters.

Europe has enjoyed an even greater boom. EUROSIF's (the European Sustainable Investment Forum) 2010 study of sustainable investment revealed a dramatic 87% hike to €5trn in assets under management (AUM) in 2009. Bond funds emerged as the asset class of choice, comprising 53% of the total AUM, while equities dropped to 33% of assets under management.

The holdings in these bond funds are wide-ranging, encompassing corporate debt, mortgage-backed securities and high yield, as well as fixed income investments tied to low-income housing, small businesses, economic development projects, infrastructure, affordable health-care firms, to job creation programmes. Neighbourhood revitalisation activities, renewable energy, green buildings and green-tech companies are also on the list.

The investment trend towards SRI bond funds mirrors that in mainstream investing. For example, in the UK, statistics from Pension Corporation show that average equity allocation for all UK pension schemes has fallen from 61% in 2006 to 46% today, while fixed income allocation jumped from 28% to 37%. One main driver for this change has been pressure from regulators, sponsors and trustees for pension funds to embrace bonds to better match their assets and liabilities, although volatile equity markets have also had an affect.

Mark Mansley, investment director at UK based Rathbone Greenbank Investments, points out that the interest in SRI bonds reflects the general interest that investors have shown in bonds since the financial crisis. "However, the BP Gulf of Mexico oil spill was also a wake-up call and ended the debate over whether ESG matters from a financial viewpoint," he adds. "It made investors look much more carefully at these factors. BP bondholders were seriously impacted and it had a significant impact on the company's creditworthiness."

Following the accident, BP's bonds fell sharply after Fitch Ratings slashed the company's rating by six notches - to just two above junk status - due to concerns over the potential cost of cleaning up the spill and meeting future liabilities.

Pension schemes that applied ESG criteria and avoided BP shares on environmental grounds might not have undertaken the same screening process for their fixed income investments in the oil giant. In addition, whereas equity holders might have engaged with the company board, bondholders would have found it more challenging to engage because of the lack of a straightforward process such as shareholder voting.

"There is no structured engagement process for bondholders," says Dominique Blanc, head of SRI Research at French research firm Novethic, a subsidiary of Caisse des Dépôts. "In France bondholders proactively engage in dialogue with the companies. They do not ask them to change their behaviour but will ask them a series of questions related to ESG issues before deciding whether or not to invest.

"Things are changing though, and the creation of a fixed income sub-working group within the UN Principles for Responsible Investment could lead to a more formal process of engagement for bondholders."

Mansley adds that engagement is not the raison d'être of the corporate bondholder. "Instead they may decide to invest and proactively support projects and initiatives that have clear social and environmental purposes," he suggests. "Perhaps the clearest example of this is green bonds [issued] by the World Bank and other development banks. However, such bonds do also provide opportunities for engagement - so there have been several discussions about which projects are suitable and which projects sustainable investors would rather avoid."

Since launching the first bond in 2008, the World Bank has issued nearly $1bn (€0.77bn) of green bonds, with the proceeds being directed to support environmental projects ranging from reforestation to low-carbon activities and alternative energy sources.

Despite the hurdles to engagement on the fixed income side, bondholders can make their voices heard. This is particularly true during new debt offerings when potential investors can take a fine-tooth comb over the prospectuses to assess a company's commitment or exposure to ESG factors. Potential investors can also air concerns as well as make further inquiries about a company's environmental risks and opportunities, labour relations, employment and supply chain practices during the roadshows or in the one-on-one meeting before an issue hits the market. They also have the ability to ask for various terms before committing to invest. Covenants are linked typically to financial ratios, but investors could ask for other social-rated covenants.

Conversations should be ongoing, says Rivkin. "We apply our own ESG criteria as well as using research from external research firms," he says. "We have always conducted rigorous due diligence and our analysts are in regular contact with a company's management. If a company is not addressing or continuing to meet its ESG criteria, or if we found a more competitive opportunity, we would sell out during the right market conditions."

Muzinich, which has a wide range of fixed income funds catering to different types of investors, recently launched the Bondyield ESG fund focusing on companies that best manage not just their economic performance but also their social and environmental impact. The fund screens out companies that its independent advisers consider to be in violation of UN-defined ethical standards around employment, human rights, the environment and corporate governance.