Integrating ESG investing into bond portfolios

by

12 Jun 2017

Bondholders have traditionally not integrated ESG factors into portfolios or held much sway when influencing the companies they invest in. But is that about to change? Emma Cusworth investigates.

Miscellaneous

Web Share

Bondholders have traditionally not integrated ESG factors into portfolios or held much sway when influencing the companies they invest in. But is that about to change? Emma Cusworth investigates.

At crisis points, however, the interests of shareholders and bondholders can diverge: bondholders’ key concern will be getting their money back, while shareholders will want the firm to survive, recover and continue to deliver value over the long term. This is when bondholders get the best seats at the table, however, and their rights are contractually assured and supersede those of equity holders.

Interestingly, though, bondholders still need to bear the position of shareholders in mind because they may end up exposed to equity risk in the event of a failure by a financial firm. Following the financial crisis, a number of governments brought in new legislation, such as the Banking Act 2009, which introduced the ‘bail in’. Under this system, where a financial firm fails, the authorities can impose a transfer of equity ownership from shareholders to creditors. This is designed to protect the taxpayer, but it underlines the role of debt as a corporate asset and binds the fortunes of debt and equity holders closer together.

VOLKSWAGEN

Volkswagen is an interesting example of how ESG factors can negatively affect both shareholders and creditors. Following the firm’s 2015 emissions scandal, the share price nearly halved, falling from €167 on 16 September to €102.8 by 5 October. A year and a half later, the price still hasn’t fully recovered, closing on 9 February 2017 at €143, over 17% below its pre-scandal level. The credit ratings on VW bonds were also downgraded by the CRAs, including S&P and Moody’s.

At the time, one of Moody’s lead analysts for VW cited “challenges to Volkswagen’s financial flexibility and competitive position”, which “heighten Moody’s concerns about Volkswagen’s internal control and governance issues, thus further weakening its rating profile”. This clearly demonstrates how concerns over environmental, governance and litigation risks are assetclass agnostic, aligning the interests of debt and equity investors. Mercer’s Brett, says: “We are increasingly hearing that when managers engage with companies they are talking about equity and fixed income at the same time. There is a lot more joined-up thinking and that message will be filtering through to companies.”

MANAGER SELECTION

Brett also reports seeing asset owners increasingly building fixed income managers’ ability to deliver on ESG integration into their selection criteria. “It is still early days,” she says, “but there is a lot of demand from clients appointing managers to hear what they are doing regarding ESG.”

The Environment Agency Pension Fund (EAPF) is one of the front runners among asset owners when it comes to ESG integration. “We integrate ESG in all our decision-making because it can add value,” says Faith Ward, chief responsible investment and risk officer at the £3bn fund. Ward says the EAPF looks for two things when it comes to selecting fixed income managers: their ability to clearly articulate why they bought a particular asset and the processes around those decisions; and how managers engage with issuers.

This is followed up, she says, with a robust oversight process to reinforce the fund’s expectations on ESG integration, and to ensure managers are improving and evolving their methods. Still, she says there are fewer managers offering this service on the fixed income side than on equity. “We would expect a few to stand out,” she says, “but we would not expect to be spoilt for choice.”

More Articles

Subscribe

Subscribe to Our Newsletter and Magazine

Sign up to the portfolio institutional newsletter to receive a weekly update with our latest features, interviews, ESG content, opinion, roundtables and event invites. Institutional investors also qualify for a free-of-charge magazine subscription.

×