From niche to mainstream

How sustainable fixed-income investing is growing in prominence, and why an active approach makes sense.

• Since the onset of the pandemic, a range of specific instruments have moved centre stage: green, social, sustainable and sustainability-linked bonds create a rich panoply of tools for investors wishing to give greater prominence to ESG considerations. 
• There is also a growing body of evidence that integrating ESG analysis into fixed income can lead to enhanced performance, highlighting the benefits of an active, selective approach.
• A consideration of sovereign debt lends itself to a similar rigour. Governance factors, in particular, have a high correlation with spreads.

The wave behind considering environmental, social and governance (ESG) issues as a key input in capital-allocation decisions is continuing and has gathered pace since the onset of Covid-19. While ESG analysis has traditionally been more closely associated with equity investing, given the ability of shareholders to influence companies directly through the voting mechanism, a sea change has been underway for some time with respect to its relevance in fixed income. Indeed, there are an increasing number of levers that can be pulled, helped by developments in the range of instruments available and an increase in supply, given the evolution of government policy in the wake of the pandemic.

Financial markets have undergone something of a regime change with the decisive introduction of fiscal policy into the mix of authorities’ tools to address economic challenges. Unlike monetary stimulus through quantitative easing, fiscal stimulus is likely to prove to be a more direct and effective way of generating growth, although many projects may have a long lead time. The increasing appreciation of the climate emergency, backed up by scientific research, has served as a catalyst for green policies which have the added appeal of being politically palatable to voters concerned about climate change.

A green recovery

Approved funding from national and sub-national governments to spur a green economic recovery has reached $949 billion.[1] Initiatives have not been limited to the environmental agenda: a sharp societal focus has come into the frame owing to Covid-19 and the need to create ‘green’ jobs and balance regional differences. Hand in hand with this development, a range of specific instruments have moved centre stage: green, social, sustainable and sustainability-linked bonds create a rich panoply of instruments for investors wishing to give greater prominence to ESG considerations.

While green bonds have long been part of the investment landscape, starting in 2007 with issuance by the European Investment Bank and the World Bank, sustainability-linked bonds (SLBs) are the new kid on the block. Launched in October 2020, these are defined as having structural characteristics that can vary depending on whether the issuers achieve predefined sustainability/ESG objectives. Their appeal is their ability to take a more forward-looking, holistic view of an issuer’s profile. This segment is fast gaining traction, and the longer-term nature of the key performance indicators (KPIs) embedded in them means that they will broaden the scope of eligible issuers and appeal to those companies that are moving to a more sustainable profile. It will also improve the accountability of issuers for the projects they undertake, as they will need to ensure that penalties for failing to adhere to KPIs are not triggered.

Performance potential

There are considerable benefits of integrating ESG analysis into fixed income, not least the potential for enhanced performance of which there is significant evidence. In a recent study, MSCI found that hypothetical portfolios, constructed with higher-ESG rated issuers, had stronger cash flows, lower systematic risk and fewer idiosyncratic risks than portfolios composed of lower ESG-rated issuers.[2] JP Morgan’s European credit research team found a significant cost of funding difference between best and worst-in-class ESG firms, with a return differential between top and bottom ESG-rated firms of 2.71% in investment-grade and 9.35% in high-yield issues.[3] It is no coincidence that the weakest performers have generally exhibited lower ESG ratings, the recent downgrade of the oil and gas sector by Standard & Poor’s for ESG reasons being a case in point.

It is here that we believe an active, selective approach comes to the fore, and which can be further enhanced by seeking to effect change through engagement. For example, we recently approached an automotive battery company to engage on a variety of ESG topics, ranging from its approach to lead-acid and lithium recycling, to supplier audits, to accessing sustainability-linked debt facilities. This privately owned company in the high-yield area is at an early stage on its sustainable journey and drew on our expertise in areas such as disclosure, KPI-setting and establishing reporting frameworks. A more nuanced approach to engagement rather than purely focusing on best-in-class operators enables us to consider and potentially invest in those companies undergoing transition to a more ESG-friendly profile.

Sovereign scruples

Selectivity and in-depth analysis are not limited to the credit universe. A consideration of sovereign debt lends itself to a similar rigour. While the range of investment instruments available may be less innovative than in the corporate bond area, the ESG issues under consideration are equally weighty. Governance factors have the greatest sway in our analysis owing to their high correlation with spreads, followed by social factors such as education, health-care poverty and income inequality. Finally, environmental considerations are also an influential factor in the mix, in evaluating aspects such as air quality, soil pollution and emissions data. While direct engagement with sovereigns may be somewhat more challenging, government representatives, central bankers and International Monetary Fund representatives can provide valuable insights, while the ultimate stick of denying capital can be a powerful lever.

In summary, the tailwinds and trends behind sustainable fixed-income investing are growing in prominence and force, aided by the creation of ESG-related incentives which encourage alignment between a wide range of stakeholders. Within the context of our holistic ESG approach, we believe an ability to draw on the increasingly wide range of available sustainable instruments and to deploy a highly active and selective approach, using our proprietary evaluation methodologies and responsible investment expertise, should help in navigating this evolving and opportunity-rich landscape.

[1] Bloomberg New Energy Finance, April 2021.

[2] How Are High-ESG-Rated Bond Portfolios Distinct?, MSCI, 5 February 2021

[3] Do Good; Get Paid: Estimating ESG Alpha in European Credit, Shivam Ghosh and Saul Doctor, JP Morgan, 8 February 2021. On file with the author, courtesy JP Morgan, copyright 2021.

Authors

Catherine Doyle

Investment specialist