Fixed Income Boutique
GameStop's recent wild ride reverberates with angry anti-establishment undertones and highlights once again that financial markets are in the firm grip of a paradigm shift from greedy profit to ESG-benefit maximization. This is backed up by the strong growth of ESG investment solutions, which is testimony to the fact that investors are seeking to have a true impact. While equity markets have been hogging much of the limelight in impact investing, fixed income markets have been catching up with green bond issuances. However, green bonds still remain a relatively small niche to secure funding for sustainable projects, whereas the vast realm of general fixed income markets is often underestimated as a powerful place for pushing sovereign and corporate issuers to implement ESG change. While engagement is an area that still has room to mature in fixed income, there are potent pricing mechanisms at play in primary and secondary fixed income markets that bond investors can use to have a tangible ESG impact.
Common perception is that impact goes hand in hand with power, which is why influencing company management tends to be considered a privilege of equity investors. Whereas equity investors are company shareowners with voting rights, fixed income investors are merely capital lenders with credit terms with less leverage on management decisions. While accurate, this view ignores that bond investors are capital providers, whose convictions are reflected in market prices and bond valuations that determine a company's cost of capital. As ESG matures in bond investing and investors increasingly practice ESG integration in their bond selection processes, bad ESG headlines will force a company to pay more on their bonds. This is because ESG conscious bond investors will start to shun ESG culprits pushing down the bond price and driving up the yield.
Critics might say the real action takes place in primary markets, where capital is allocated, and not in secondary markets, where it only trades hands. However, this is only partly true in fixed income markets. With very few exceptions, companies and governments are serial issuers that tap the market repeatedly in order to refinance themselves. This means they roll over their debt and any primary issuance is priced off the secondary market. So, if a company has a questionable ESG track record, investors are likely to be wary of the risks associated with this. Consequently, they are likely to demand a higher yield on the issuer's bonds in the secondary market, which has a direct effect on the pricing mechanism of new issuances in the primary market. Higher yields translate to higher interest expense, which hits the company where it hurts: the bottom line.1
Engagement has risen to fame through belligerent equity investors forcing companies into action with the goal to weed out obvious weaknesses for the benefit of shareholder value maximization. In fixed income investing, engagement is a less glorious affair. Without the option of proxy voting, bond investors' power to engage with issuers is rather implicit than explicit and must develop further in order to gather full momentum in bringing about change. As capital providers, bond investors have direct access to company management and government officials and are able to raise contentious issues and address potential shortfalls – the bigger the bond share the investors holds, the better, of course. However, to avoid being palmed off with a polished PR answer, more collective action is required from bond investors who tend to only come together in the case of defaults and debt restructurings. The good news is that, in light of ESG's fast advance, it might only be a matter of time until bond investors find a common forum to press issuers on ESG concerns - not least because ESG improvement can have a direct bearing on credit quality.
So, bond investors do have quite some sway. This comes with responsibility since leaving low, yet up-leveling, ESG performers behind by excluding them from an investable universe would cut them off from funding barring any further progress. There are two aspects, which can prevent this from happening:
Market mechanisms will incentivize issuers to improve on ESG concerns. As described above, low ESG performers unwilling to change are likely to be penalized by the market with a higher yield. Conversely, improving ESG laggards are likely to see their funding costs decrease over time as they progress on ESG, while investors benefit from capital gains as bond prices rise. This is a win-win situation, which will strongly incentivize companies to model their behavior on their more successful peers. At the same time, investors are encouraged to scour the earth for issuers who are on a positive ESG trajectory to harvest the returns associated with the spread tightening potential that these issuers harbor.
The pre-requisites for this to work are a flexible approach to portfolio construction and in-depth, bottom-up research on single issuers. After identifying issuers with improving ESG potential, one option is to go for an active strategy that aims at keeping the overall ESG score of the portfolio high, which allows for the inclusion of improving ESG laggards, albeit at a lower weighting. These weightings are the result of current ESG practice and signs of improvement or decline. This way, improving ESG laggards are able to secure funding for their operations and liquidity for their bonds while the investor maintains the general quality of the portfolio, which is protected from unnecessary risk.
If done right, ESG investing can beat the market defying those who dismiss ESG as a costly affair that detracts from portfolio returns. In emerging markets, there is strong evidence for this. A simple comparison of two EM sovereign bond indices already shows that the ESG version outperformed the non-ESG version last year.2 This only captures the beta effect while any potentially return-enhancing impact of active management is still unaccounted for. An active bond manager who knows how to exploit mispricings and market inefficiencies, select bonds bottom-up and differentiate between ESG laggards willing and unwilling to change has the potential to add alpha to the positive beta of ESG issuers. Therefore, there is no reason to assume that investment managers must run the risk of failing their fiduciary duty towards their clients if they go ESG. In fact, ESG fixed income management can be a valuable source of returns boosting the portfolio's bottom line.
1 This assumes that the bond yield is equal to the coupon rate.
2 Between 1 January and 31 December 2020, the J.P. Morgan ESG EMBI Global Diversified retuned 5.78% while the J.P. Morgan EMBI Global Diversified returned 5.26%, source: Bloomberg. Past performance is not a reliable indicator of current or future performance.