Scott Freedman, Fixed-income portfolio manager Newton Investment Management
When it comes to assessing the risks around fixed income investments, environmental, social and governance (ESG) factors have traditionally been viewed through the rear-view mirror, when something has already gone wrong. We believe it makes sense to employ a forward-looking assessment of ESG-related credit risks, to help reduce the chance of potential future hazards.
Having integrated ESG considerations into credit analysis for several years, we have always believed that considering the materiality and impact of ESG factors on companies and countries is crucial to risk assessment. In our view, it results in better decision making, and should, if done with diligence and consistency, result in superior risk-adjusted returns because ESG factors can have a material impact on credit risk and, therefore, performance.
In our engagement with companies, the environmental, or ‘E’, factor often comes to the fore, with conversation increasingly focused on trying to limit the environmental impact of climate change. In time, ‘S’ and ‘G’ factors may also become more regularly considered in a more explicit manner (at Newton they already form an important part of our ESG assessment for companies and countries). However, in fixed-income investing, it is probably fair to say that ‘E’ factors are the most tangible to perceive and quantify – although this is not to suggest that measurement is easy.
Fixed income and equity: how the ESG approach differs
Another question we are often asked is how an ESG engagement approach differs between fixed income and equities, given that bondholders do not get to vote on corporate policy. Owing to the risk asymmetry between bonds and equities, downside risk mitigation is more important for fixed income (bonds have limited upside but similar downside risk to equities). Generally speaking, a company with a strong ESG profile should benefit equity investors and bondholders; differences will be driven by management’s financial policies and decisions about whether to prioritise debtholders or shareholders. Another key difference is that bondholders have a variety of relevant ESG-themed areas available for investment that are not available to equity investors, such as green financing, universities, development agencies and social housing. Debt investors can also invest in private companies – one of the most powerful engagement areas for fixed income. When engaging with issuers that have weaker credit ratings and/or are private (especially in the high-yield sector where bondholders often provide a company’s only access to capital), we find that our questions, views and recommendations on ESG issues are increasingly being heard, which affords us the greatest chance of effecting positive change. Companies are having to answer more bondholder questions relating to ESG strategy and investors are taking an increasingly dim view of those that are ill-prepared.
This perspective (and the powerful role bondholders can have in driving better corporate behaviour) was underlined by Knut Kjaer, founding chief executive of Norway’s sovereign wealth fund, who said at a recent conference in London that debt investors could have a more meaningful impact on the world’s biggest carbon emitters than equity investors. “If you take the 100 most fossil fuel intensive companies, it’s only 40 or 41 of them that have listed equities. All of them are in the debt markets,” he said.
Credit investing with an ESG lens is about more than simply risk mitigation; it is about seeking out opportunities. Identifying issuers that we expect to receive an improved ESG assessment over time, often through engagement, can result in capital appreciation as the transition is reflected in rating upgrades and a lower cost of capital over time.
We have for many years worked with our in-house equity and responsible investment analysts when analysing and engaging with companies from a fixed-income perspective. In situations where we hold the equity and debt of an issuer, it can provide a powerful tool with which to focus a management team on enhancing its ESG credentials. Those companies that do engage successfully can find themselves upgraded by ratings companies and some are now using their improving ESG rating to their advantage by securing more attractive bank loan terms.
Finally, this is not just about returns to investors, it is also about responsible investment. Asset managers and asset owners can no longer afford to focus solely on maximising short-term returns if doing so comes at the expense of other stakeholders, as the associated bad publicity and longer-term negative consequences can testify. At this point, we cannot say for sure whether ESG factors are properly factored into credit pricing, but it seems highly likely that, as ESG concerns rise up the agenda for society, governments and investors, we will start to see growing pricing bifurcation between the strong and the weak ESG performers.