The process of incorporating ESG into fixed income is different to that for equities, but it is even more important to do so, argues My-Linh Ngo
Environmental, social and governance (ESG) investing is a long term theme, representing an area that will increasingly feature in client mandates.
While it has traditionally been discussed in the context of the equity asset class, we believe it is a good fit with fixed income investing.
Indeed, academic studies show quite consistently that incorporating ESG is most beneficial in terms of managing downside risks. In fixed income, it is all about mitigating downside risk, as the upside is capped.
Though default may be the worst case scenario, there are also intervening risks to investors, including downgrades in the quality of the debt, which will impact investor returns.
The business case is further supported by the fact that the risks for fixed income investors of investing in the wrong bond are greater than for investing in the wrong equity asset. Equities are most commonly traded on an exchange, making them more liquid.
In fixed income, the investment universe is larger, more complex, and there is more variation in quality and number of investible instruments. This reduces the level of liquidity in the market for some bonds and potentially increases associated transactional costs.
ESG risks may impact bonds differently to equities
Despite the clear rationale for incorporating ESG into fixed income, in practice it can sometimes appear that equity prices react faster and more sharply than bond ones to a negative event, which would appear to underline the business case.
This is not so, but it merely reflects the need to recognise and understand the different drivers of bond and share prices and how these interplay with ESG risks.
For equities, share prices are often driven by news flow and sentiment about growth prospects (e.g. in earnings, profits), rather than just fundamentals. As such, there is more likely to be direct and immediate sensitivity to ESG factors.
For fixed income, the emphasis is focused on fundamentals (e.g. cash flows) with the price of a bond influenced by changes to expectations such as financial strength of the issuer/risk of credit losses, i.e. creditworthiness.
This means there is potentially less direct sensitivity to ESG risks as the creditworthiness of the issuer can act as a buffer to the ESG risk, potentially diluting and/or delaying the impact.
As such, although an ESG risk may be considered significant in terms of a business risk, it may not be a financial risk that results in a change in credit rating or impacts bond prices or spreads materially.
An additional point to make is that due to the asset class's complexity, different instrument types and durations of bonds, the relevance of ESG risks may vary. This means that for the same issuer, the ESG risk of holding an associated bond may vary depending on which bond is held, for how long it is held for, and its maturity term. This makes ESG risks relating to fixed income particularly multi-dimensional.
Clearly, what has just been outlined is a very simplistic explanation of how and why equity and bond prices may react in different ways to business risks (including ESG related ones). In reality, price reactions will most likely be quite idiosyncratic, reflecting company-specific circumstances.
Nonetheless, while the responses may vary in their timings and quantum, it would be true to say that both equity and bond prices will react in some way (given they do interact with each other) – as illustrated by the price performance of the global oil and gas company BP, following the Deepwater Horizon oil spill in April 2010 (Figure 1).
ESG risks can and do impact creditworthiness
Credit rating agencies themselves have acknowledged that ESG can – and does – impact an issuer's credit ratings.
Standard & Poor's (October 2015) states environmental and climate risks are indeed material to business risks in oil refining and marketing, regulated utilities and unregulated power and gas industries, where environmental regulations and weather events tend to have a more direct impact on credit quality than in other sectors.
Moody's has developed a sector environmental heat map to illustrate how it sees environmental risks impacting sectors (Figure 2) and has also shown that the risk of carbon reduction policies on non-financial corporates can play out in terms of three primary credit effects; direct costs, disruptive technological shocks, and policy uncertainty/regulatory risk.
Commenting on the future, Standard & Poor's (October 2015) believes that environmental and climate risks will likely grow and "could lead to a more widespread weakening of corporate credit profiles and subsequently more downgrades than in the past".
ESG investing can be positive
Whilst it is more complex, incorporating ESG factors into fixed income also has greater potential to make a difference in terms of beneficial societal outcomes, specifically:
- Relative size of the market: the size of the fixed income market is much larger than equities (two thirds versus a third) and more long term in outlook, with potentially less volatility.
- Type of financing needed: in the context of global environmental challenges such as climate change, it has been stated that significant future investment is required, the majority of which is needed in infrastructure. The equity market alone cannot meet this need.
- Direct influence: in areas such as climate, fixed income investors may have more influence over companies such as state-owned-enterprises which are more likely to issue debt than equity.
The need to select the most appropriate ESG investment strategies for fixed income
As with equity investing, a robust investment risk management process is crucial when considering ESG factors for fixed income. In doing so, we find that some of the most common ESG investment strategies work better than others (as illustrated in Figure 3).
For instance:
- Negative screening strategies: approaches that exclude whole sectors may work in some sub-asset class strategies but not others, depending on the size of the sector as a proportion of the investment universe.
- Best in class strategies: the separation of investment grade (IG) and high yield (HY) issuers within the same sector as is common in fixed income strategies, which means this approach is not particularly workable as you are not actually picking from the whole universe - just part of it.
- Engagement strategies: whilst this is still possible for corporate bond strategies, investors need to be pragmatic in terms of their expectations given it will be more difficult without formal legal rights of equity investors. But success is possible where investors are resourceful and creative in their approach.
- Thematic strategies: this approach can work – as we have already heard – the scale of investments needed to tackle climate change means green infrastructure is urgently needed. One way for fixed income investors to tap into this is via the green bond market.
As such, in our view, the most compelling strategy for fixed income, which allows for the different characteristics of bonds and their potentially differentiated ESG risk profile, is ESG integration.
While it is clear that ESG is moving up the agenda for investors in fixed income, there is clearly still some way to go before it receives the same attention as equity investors.
Progress needs to be made in key areas such as an increase in the availability and quality of issuer-level ESG data, improvements in the quality of ESG credit rating analysis (including better addressing the issue of time horizons of credit analysis and the long term nature of some ESG risks), and further development of ESG investment strategies which are tailored for fixed income.
Given the scale of interest in fixed income ESG, we are confident this will come.
My-Linh Ngo is an ESG specialist at BlueBay Asset Management, a global fixed income manager. For more information about BlueBay's ESG investment risk approach, visit the website.
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