Fixed income 2021
Unfix your thinking.
Given the bond market is the largest capital market in the world, we think the question of how bond managers can invest responsibly, or sustainably, is of crucial importance and an ever increasing focus for investors. The trouble is, especially for those new to this sphere, that there are many complexities around this whole topic for debt investors – and knowing where to start can be difficult, with so many moving parts and many regulatory changes still being implemented.
So to keep things simple, let us start with the two biggest bond market sub-sectors, government and corporate bonds, and leave discussions on the much smaller green bond market for another time.
Judging whether a company or government is acting responsibility and sustainably essentially boils down to this: a value judgement. Unlike, say, credit ratings, which are based predominantly on objective measures such as leverage (which is why credit ratings are usually so highly correlated), an ESG rating is far more subjective (and why they are usually so uncorrelated). Of course, many objective data points, such as emissions data, diversity of workforce and track record of doing the right thing for stakeholders all go towards forming that value judgement - but how you weigh those data points and your key motivational forces can drastically alter the ultimate score. This means that how any ESG database, or portfolio manager, makes these value judgements, is the number one question we think any investor should ask before investing in any ESG fund – because the outcomes can be so wildly different.
A favourite example of mine that really brings this alive would be Tesla, which often splits the community when it comes to ESG score – is it a ‘good’ or ‘bad’ company from an ESG perspective? Most people would agree that electric vehicles have the potential to be a significant force for good in helping to combat CO2 emissions, and this is why some ESG scores you’ll see are high for Tesla. On the other hand, leaving aside considerations around energy inputs into the car manufacturing process and the specialist components for electric vehicles that are more resource intensive, is the governance structure at Tesla. With so much power in Elon Musk’s hands, should this be considered as a structure that will sustainably ensure the best treatment of stakeholders? Musk has certainly had some ‘unusual’ behavioural traits in the last few years it is fair to say, and those governance concerns are one of the reasons why other ESG databases and investors score Tesla poorly. Coca-Cola is yet another example where as a huge user of plastic it scores poorly on some ESG databases, yet well on others which clearly must not weigh use of plastic as highly. Which one is right?
So the choice of ESG database used, and/or the methodology employed, is a primary concern. Another primary concern regards the coverage of ESG databases for credit investors is how deep into the universe of credit do these ESG databases cover? Sadly, from our experience not far enough is the answer. Our studies show that most third party ESG databases struggle to cover even half of the public credit markets, partly because many bonds are issued from special purpose vehicles, mutual (not for profit) enterprises, or are from small cap equities. This means it is not an easy nor automated process to ESG score a typical credit portfolio. The large gaps in coverage that you would expect to exist need to be covered and scored by portfolio managers themselves, and of course this can be very costly in terms of time, personnel and resource to do this properly – ultimately however we believe credit portfolio managers must do this work themselves as they are the stewards of their ultimate asset owners’ capital.
But this coverage, and in particular the judgement issue, perhaps runs deeper than might be recognised at first. For example, how can a third party fund rating service claim with authority that bond fund A is more ESG friendly than bond fund B? Could it be because bond fund A happens to own more Tesla and Coca-Cola which they themselves have determined as ‘good ESG companies’? Alternatively, another rating service may claim that bond fund B is ‘better’ from an ESG perspective, precisely because it does not have Tesla nor Coca-Cola at al. Ultimately, we believe only the ultimate end fund buyer is in a position to make these value judgement comparisons between funds, and that the answer to this problem can only be transparency from managers. Consequently we spend a lot of our time explaining the investment decisions we’ve made, the ESG scores we’ve come up with, and the carbon footprint of any issuer we may invest in as well as our own.
What about government bonds? Again this is an ESG issue that can have binary outcomes, because of some uncomfortable truths about governments and/or countries. For example, how many of the G7 nations that are typically a core part of government bond portfolios not only buy or manufacture weapons, but also use them or threaten to use them? Do governments generally hold true to promises made come election time, or do they end up disappointing? Under a value judgement system, we cannot hand on heart say any government we might otherwise consider deserves to be included in an ESG fund.
However – there is one huge mitigating factor, which is the much focused on risk-off properties that government bonds tend to provide when markets are going through periods of extreme stress. Witness March 2020 for example: COVID-19 fears meant risk assets sold off aggressively, yet government bonds actually went up in value, helping to protect investors when they most needed it. Even ESG funds in our view therefore cannot take the moral high ground here: they need to retain the ability to allocate capital to government bonds to try and protect that capital in extreme periods like March 2020. So in our view a clear distinction needs to be made meaning ESG funds should only use government bonds when purely for risk-off hedging purposes, by which investors generally mean core rates such as US Treasuries, German Bunds or UK Gilts. By contrast, any other government bonds should only be included in sustainable strategies if they have passed the same scoring threshold you set for companies. So far, no governments we’ve looked at have met that high bar.
Ultimately we think bond managers most certainly can invest responsibly. But ‘responsibly’ certainly does not equal ‘easily’, and significant time, energy and resource must be expended by credit investors in getting enough quality data together to make informed decisions. Even then, very large differences can appear between those with differing values, and thus fund buyers must be given the information as well so that they themselves can make their own informed decisions about how companies, and governments, are scored by their respective managers – but a great starter question for any ESG investor might be: “how did you arrive at your score for Tesla”?