Fixed income 2021
Unfix your thinking.
If you’re not plugged into ESG, you’re chasing a Tesla with a Trabant. Today’s reality is that more and more investors want to do good and, in addition, regulatory change is increasingly requiring investors to meet evolving ESG standards. With fast change (and progress) comes a need to adapt, which then requires a period of learning and adjustment.
As an investor possibly thinking about where and how to include ESG products in your portfolio, this article should help. In it, our three experts challenge you to unfix your thinking by busting three myths related to ESG and bond investing.
But before we get into the myths, let’s first look at the one thing all investors are looking for, performance. Think of this as the bonus myth of this article, a four-the-price-of-three kind of deal, and that myth is that ESG is a detractor to performance. This need not be the case. To give just one example, using emerging market hard-currency sovereign indices, during the past seven years (according to a research from JP Morgan), the emerging market ESG index has delivered higher returns and lower risks than the broader index (see chart below). Why is this? Well, myth three will reveal the reason for that, while myth two will explain why an active approach is needed, when bond investors want to consider ESG in their investment processes and myth one, how bond investors can be a force for good.
Fixed income markets are often underestimated as a powerful place for pushing sovereign and corporate issuers to implement ESG change. Common perception is that impact goes hand in hand with power, this is why influencing company management tends to be considered a privilege of equity investors. However, there are powerful pricing mechanisms at play in primary and secondary bond markets that investors can use to have a tangible ESG impact.
Whereas equity investors are company shareholders with voting rights, fixed income investors are merely capital lenders with credit terms and 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, which determine a company's cost of capital. As ESG grows in importance for bond investors and they increasingly integrate ESG into their bond selection processes, bad ESG headlines will increase the cost of financing. This is because ESG conscious bond investors will start to shun ESG culprits pushing down the bond price and driving up the yield.
Now, critics might say the real action takes place in primary markets, where capital is allocated, and not in secondary markets, where it only changes hands. However, this is only partly true. With very few exceptions, companies and governments are serial issuers that tap the market repeatedly in order to refinance themselves and also provide a benchmark for secondary market trading. So, if a company has a questionable ESG track record, investors are likely to be wary. As a result, they will 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 expenses, which hit the company where it hurts: the bottom line.
Engagement has risen to fame through belligerent equity investors forcing companies into action to address obvious weaknesses and thus maximize shareholder value. In fixed income investing, engagement is a less glorious affair. Without the option of proxy voting, bond investors’ power to engage with issuers is more implicit than explicit and must develop further in order to gather full momentum to bring about change. As capital providers, bond investors have direct access to company management and government officials and are able raise contentious issues and address potential shortfalls – the bigger the share of bonds 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 will only be a matter of time until bond investors find a common forum to press issuers on ESG concerns - not least because, ultimately, ESG improvement can have a direct bearing on credit quality.
We believe an active, high-conviction manager needs to look beyond aggregate ratings.
Bond investors are accustomed to credit ratings, which are driven by concrete factors such as leverage or cash flows. The approaches of the three big agencies, S&P, Moody's, and Fitch are similar and, in fact, you rarely see extreme differences in the credit ratings of the various agencies. However, the ESG rating industry is different; it is much younger and more subjective. In fact, the approaches, and therefore the results, of ESG raters vary widely.
Our colleague Lara Kesterton has quantified these differences in her article. There, she explained that there is a strong level of agreement among rating agencies when comparing credit ratings, which have a correlation coefficient of 0.964, close to the maximum of 1, meaning agencies are in almost perfect agreement. However, when it comes to the leading ESG raters, the correlation is 0.493, more than half way to zero, which indicates ratings are half way between perfect agreement and complete randomness.
Beside subjectivity, data quality is another problem for ESG ratings. Not all companies are ready to deliver all the information ESG Rating agencies require for their scores. For example, smaller companies (e.g. high yield or emerging markets) are often not as advanced when it comes to reporting and disclosure and, therefore, get a weaker score due to the lack of information, or sometimes receive a gap-filler score such as a sector average. Thus, it is critical that analysts really understand the ratings methodologies when interpreting ESG scores.
Considering the problem with data quality and this level of disagreement, we believe that investors should not solely rely on a single ESG rating, but use a broad range of information to identify “ESG leaders”. We are active managers and our credit team would not buy corporate bonds based solely on credit ratings. So why should we base our ESG-related decisions on ESG ratings alone? They say, “Focus on the journey, not the destination.” This describes ESG analysis well, as understanding single ESG risks and appreciating their impact on performance gives an analyst more value than a single-digit output from an ESG rating agency’s model.
While history helps us understand the future, another reason not to rely on a single rating is the fact that the ratings look at the past. This is something ESG ratings have in common with credit ratings. “We are not a news agency”, I once heard at an ESG-rating seminar, which is true. This information lag also creates opportunities. In the corporate bond world, you often hear about “rising stars,” companies whose ratings change from high yield to investment grade, creating a handsome pay-off for early investors. A company may not currently have a high ESG rating, but our fixed income portfolio managers (Anna Holzgang, in particular, who will be dispelling myth number three below), focus on the transition of a company to an improved level of ESG. On one hand, you can find and invest in an ESG rising star, an ESG leader. On the other, you are supporting companies that are on the way to change our world for the better.
Let us take an example, the utility sector. Here we focus on utilities that are contributing to the transition to clean energy. So, we also accept utilities that don't have the highest ESG rating yet, but where we see an investment opportunity where we find a tangible improvement in the business model towards energy efficiency and renewables.
It is particularly important that ESG risks are well managed when these risks are high. So we do not automatically exclude companies with high ESG risks. Portfolios may include some companies with above-average ESG risks, but an investor should review those risks to determine if they are well-managed and the company has a clear transition plan to reduce risks (see table below). This also means that an investor may want to exclude the worst performers and laggards on ESG risk management. Focusing on the ability of companies to manage ESG risks has an additional benefit as our experience suggests that issuers who actively engage on ESG issues tend to have better overall risk management.
Throughout my investing career, I have noticed that excluding a significant part of the investment universe, the so called “best-in-class” approach, is not the optimal way to go. For example, we may exclude electricity-generating companies that derive over 10% of their revenues from coal-fired power, but where companies have a clear exit strategy, we might raise the revenue threshold to 25%. We want to support and be a part of a firm’s journey when they are taking tangible actions to improve on ESG: We have clear limits though, such as avoiding the most risky segments and tail risks stemming from bad governance and large exposure to environmental and social incidents.
We do not impose moral or ethical values, but focus on material ESG risks. Therefore, an investor should keep exclusions to a minimum and this helps achieve sufficient diversification. A key question is; what material impact will an ESG risk have on a company's cash flows? Unmanaged sustainability issues can have a significant impact on a company's financial flexibility. If governments decide to accelerate decarbonization efforts and decide to increase CO2 taxes and a company does not prepare properly, the negative financial consequences would be tangible. Therefore, ESG risks can have a direct effect on a company’s financial performance and affect investor returns.
We believe that ESG considerations are an integral part of every fixed income strategy, not just sustainable strategies: all bond investors should integrate ESG into their analyses of both sovereign and corporate issuers.
Dispelling these three myths has hopefully helped you to consider ESG and the opportunities it opens up for fixed income investors. With rapid change comes a need to gather, analyze and understand the ramifications of the changes we are facing. It always requires us to unfix our thinking from our previous fixed perceptions. As you have read in this article, embracing ESG in fixed income investing does not prohibit engagement, nor does it have to curb your allocation choices. Furthermore, it can enable high-conviction, active investors to reap rich rewards.