For sustainable investors, bonds no longer only come in green: ESG’s influence has increasingly spread to mainstream credit.
Sustainable investors have broken new ground. They are no longer satisfied with applying environmental, social and governance (ESG) principles to equities and energy-efficient properties to help build a better world. They have their sights set on fixed income and are accessing the market in a way that they could have only dreamt of 10 years ago.
Green bonds have traditionally been the route to adding sustainable income streams to a portfolio. But investors following such strategies are no longer limited to bonds that fund projects which are designed to reduce climate-damaging gas emissions. In modern ESG-led portfolios, green bonds sit side-by-side with mainstream paper.
The sustainable bond market has been expanded by asset managers launching specialist funds that house ESG-compliant corporate and sovereign debt. The reason, as always, is to meet demand.
Indeed, in 2017 $155.5bn (£119bn) was raised by issuers of green bonds, a 78% improvement on the previous year, according to Climate Bonds Initiative, a not-forprofit industry body. In the first six months of 2018, $78bn (£59.6bn) was invested in the market, an 11% rise on the same period 12 months earlier.
Yet while this growth is high, it is not high enough to meet demand. The green bond market remains little more than a drop in the ocean when compared to the $110trn (£84.3trn) that fund manager Pimco says the global bond market is worth. ESG-led investors, therefore, have been offered alternatives in the mainstream debt universe that meet their needs.
This move to bonds that do not trade in a green index but have been identified as sustainable has won the seal of approval from Calvert, a US-based responsible investor. In a blog, its fixed income team pointed out that not all sustainable bonds are labelled ‘green’. They believe that such opportunities are equal to or are even better than those offered in the green bond market. They are not alone.
Of the 79 institutions Investec spoke to for a fixed income survey, 35% incorporate ESG into their fxed income portfolios. This is a strategy that is being promoted by the World Bank. A report it authored alongside Japan’s Government Pension Investment Fund concluded that using ESG factors when making investment decisions in the fixed income market could cut risk and generate more stable returns.
A supply and demand imbalance is not the only catalyst driving investors to search across mainstream bond markets for ESGcompliant income. While green bonds provide an avenue to help build a better world their impact is limited. Green bonds are a narrow way to approach ESG in fixed income, says David Czupryna, an ESG product specialist at Candriam Investors.
“Green bonds are about the environment,” he adds, “and ESG is much more than only looking at the environment.” His colleague, Fawzy Salarbux, the firm’s global head of consultant relations, adds that green bonds also do not offer the social and governance factors usually found in ESG strategies. “Green bonds are being seen to be doing something in ESG rather than attacking the problem from a wider perspective,” he says.
This concern is also being addressed by Legal & General Investment Management (LGIM). Madeleine King, the firm’s co-head of investment grade research, says that a sustainable approach to investing is not just about what the capital raised from a green bond is funding. It is about the business behind it.
“When managing money for our clients, we would much rather invest in a company that we think is doing ESG well across the board than in the green bond of a company that maybe we don’t like that much,” she adds.
The problem with mainstream bonds is that it could be difficult to measure their non-financial impacts if the cash investors lend to a company is not being used for a specific project. One way that some are doing this is to select bonds based on one or some of the UN’s 17 sustainable development goals, which were unveiled in 2015 to help improve the world by 2030.
Dutch asset manager Robeco is one example. In 2010, interest from its clients led it to launch an ESG corporate bond fund – the €900bn (£801.6bn) Robeco Euro Sustainable Credits. The fund targets bonds issued by companies that meet the UN’s good health and wellbeing goal. So it considers paper issued by pharmaceuticals, health insurers, medical device-makers or companies that provide clean water.
Traditionally, ESG investing has been an equity thing, but that has clearly changed. “Some have a pre-conception that ESG only applies to equities; that is not our view,” says Jennifer O’Neill, an ESG and responsible investment consultant at Aon. “It is applicable across asset classes.”
It is a theme that more and more of Aon’s clients are asking questions about, especially around how bond issuers are incorporating ESG factors into their decision-making. “It is a fast moving and growing trend,” O’Neill says. “Greater attention is being paid to ESG in fixed income, which is a step in the right direction.”
A number of funds share her view with 15% of ESG-led funds investing in bonds, according to Bloomberg’s research of almost 1,900 vehicles, compared to a surprisingly low 62% with equities in the portfolio.
Robeco executive director and credit manager Jan Willem de Moor describes ESG integration in fixed income as “a hot topic that has become hotter in recent years” among pension funds and insurers.
LGIM’s King has also witnessed rising interest in ESG-led fixed income. “It has stepped up in the past year or two,” she adds. “It is rare that ESG doesn’t come up in a client meeting now, whereas three years ago that wasn’t the case.”
Legislation could be the catalyst that has turned interest in this market into investment. Regulators and pressure groups are focusing on luring the private capital needed to fund a shift to a better world. Governments cannot shoulder the financial burden themselves.
This year has seen the launch of the European Commission’s plan to create a more sustainable economy based on a set of recommendations by a High-Level Expert Group (HLEG). More recently, UK trustees received advice on this issue from the Department for Work and Pensions (see page 24). Perhaps these are helping the message filter down to the end investor.
Catherine Ogden, a sustainable & responsible investment manager at LGIM, highlights this regulatory push is a factor behind an increasing recognition that ESG factors are financially material. “There is also an awareness that what ESG means is evolving,” she adds. “It has moved from the spectrum of ethical investing to pure divestment and to understanding that ESG is about risk and opportunity, not ethics.” This “greater understanding”, Ogden continues, is putting pressure on pension schemes to factor in what their members want now and will be wanting in future.
MEASURING THE DOWNSIDE
Traditionally, when it came to ESG it was easier to focus on equities because some companies, especially those which are listed, disclose more non-financial infor mation. In fixed income, an investor’s research centres on the prospectus, so there is a lack of transparency in this area. Another barrier could be that assessing the ESG factors of a company’s debt is different from assessing the ESG factors of its equity. The environmental, social and governance dimensions of the business are considered, but that is largely where the similarities end.
On the equity side, investors are likely to be thinking about short-term aspects such as the next good news event or dividends, whereas on the debt side an issuer’s ability to repay the loan with interest is likely to be at the top of the checklist.
“Equities are more about the opportunities, while fixed income is more about the downside risk,” says Kevin Kwok, MSCI’s vice president of ESG research.
Downside risk includes the quality of the debt an investor holds being downgraded. The worst case scenario, of course, is a default, but there is also a lack of liquidity in some bond markets that investors should consider when deciding if the reward is worth the risk.
“It is not only about finding opportunities, but it is about identifying risk and how far the downside goes. That is paramount,” O’Neill says.
A bond scoring high on an ESG scale is likely to be a lower risk investment. Scott Freedman, a fixed income portfolio manager at Newton Investment Management, says that such factors can have an impact on credit quality. “For that reason, ESG provides another level of risk analysis,” he adds. “Poor governance could have an impact on issuers and could see them default. An ESG approach could help to give investors a better idea if debt is suitably priced.”
Willem de Moor adds that as a credit investor he is not specifically looking for the best performing companies. “As a bond investor you don’t have much upside, but you do have a lot of downside.” Robeco looks at companies as a whole when searching for ESG-compliant paper. “It is not bond specific, it is company specific,” Willem de Moor says.
LGIM looks for risks that could affect the credit quality of a bond and therefore its returns. “We are a glass half empty market,” King says. “It is all about picking up on the risks as opposed to thinking about the rewards.
“A company with a lot of green revenues by definition might have lower risk, but it is more about spotting risks across the board,” she adds. “So it is not just as simple a green revenues and green strategies, it’s a whole host of environment, social and governance risks.”
David Todd, head of global IG & EM credit research at Invesco Fixed Income, says that his analysis starts with screening or assessing a company’s ESG profile. “You can’t tune an engine for higher speeds or better fuel economy until you have diagnosed where it might be possible to gain that extra performance from.
“If we are investing in companies, we want them to perform,” he adds. “However, gaining the experience to produce optimised engines takes time, it is a journey and a long one at that. “Some people might think that bondholders only care about getting their money back at some near-dated maturity, but if refinancing options dry up, the risk ofdefault goes up.”
A lack of data on the ESG factors in bonds when performing such downside research could be holding the market back. Consequently, the World Bank calls for more robust research in this area to increase supply or to make such bonds stand out. It also wants to see more innovative products created to meet demand.
Candriam’s Czupryna does not agree that a lack of credible data has held the market back. Often larger companies publish stability reports with their annual accounts. Then there is data published by specialist ESG providers, which Candriam combines with the reports complied by its own analysts, so it does not depend on external data to make decisions. “So I wouldn’t say that this is holding back the emergence of the ESG market,” Czupryna says.
It is more of a challenge with smaller companies to get the depth of information that is usually provided by some of its larger peers. It can also be tough when monitoring companies that are based in emerging markets. However, Kwok says that smaller companies are disclosing more data now. “It brings more investors into the mix.”
CAN WE WORK IT OUT?
Engaging with management is a big part of ESG. The thinking is that sometimes it is better to change a company that has bad practices rather than avoid it and let the bad behaviour continue.
While this is common practice for larger shareholders, it could be difficult for bondholders. You don’t get the same privileges as shareholders especially when it comes to voting on company matters, such as executive pay. Getting hold of management for a chat could also be difficult.
If you are not also a shareholder in a particular company there could be other ways to get the board’s attention. You could join a coalition of investors that includes shareholders to create change in these companies. “Acting together investors have more weight,” Czupryna says.
King does not believe that bondholders necessarily lack influence. “Ultimately, we are the ones who are lending companies money,” she adds. “If they can’t finance, then they can’t continue to do business.” So the primary issuance stage or a refinancing could be the perfect time to speak to management about change. “There is scope here for engagement to take place,” says Aon’s O’Neill.
In Robeco’s experience, bondholders are not being ignored. “It is fair to say that companies are listening to the bondholders, although traditionally it has been a shareholder thing,” Willem de Moor says. Newton has proved that successful engagement is possible between issuer and bondholder. Freedman points to an example of when the firm successfully spoke to the management team of a UK food manufacture about its lack of disclosure.
Newton bought debt in German car giant Volkswagen issued in March 2017 following its emissions scandal in 2015. “The company issued debt at what we saw as an attractive concession to help it pay its regulatory fine, and we believed that there was sufficient evidence of the beginnings of an improvement in its corporate culture,” says Freedman. “Private companies and companies with low credit ratings have limited avenues to raising capital, so it is important that they listen to what bondholders are saying,” says Freedman.”
The differences between applying ESG factors to bonds and equity do not end at deciding if an investment can meet its debt obligations or afford pay progressive dividends. When it comes to bonds the universe is wider than that for equities as investors also have the option of buying paper issued by governments and quasigovernmental organisations.
Applying sustainable principles to government debt assessments has meant that for some ESG is challenging conventional investment wisdom. The risk-free rate is not looking as risk-free as it used to be in some investors’ eyes.
Debt issued by the UK and US governments is a super-liquid cornerstone of many portfolios, but this paper does not meet the ESG standards set by some asset managers. Indeed, some believe that UK and US sovereign debt is tainted by the policies of their government.
Hawksmoor Investment Management does not hold any US paper in its Ethical Sustainable Fund. President Trump’s denial that climate change exists and the human rights issues surrounding Guantanamo Bay have put it on the fund’s blacklist. The Rathbone Ethical Bond fund does not invest in gilts due to the UK government’s spending on armaments.
Decisions such as these could be a problem for pension schemes that need to hold high-grade debt. Alternatives could be paper issued by other governments, the European Investment Bank, the European Bank for Reconstruction & Development or AAA-rated corporate debt.
Willem de Moor, however, warns investors that these should not be treated as gilt proxies as they do not have the same safety profile.
If another financial crisis hit, this type of debt would not act like high-grade sovereign debt, but there are other reasons for investing than just for safety.
“Bond investors have the ability to provide financing for a range of socially and environmentally beneficial investments that are not available to equity investors. Examples include supranational development agencies, green bonds, social housing, and other not-for-profit organisations,” says Freedman. These are the decisions that have to be made by the investment committees of pension schemes.
If they get it wrong they could be forced to sell assets to pay their members’ benefits. This conundrum could lead investors to question if ESG strategies go too far by blocking out what is considered to be the closing thing to a risk-free investment. This could be the next issue that ESG strategies will face, but for now bonds look like an established part of a sustainable investment portfolio.