In fixed income, a key application for ESG information is to inform analysis of issuer creditworthiness. ESG issues, such as corruption or climate change, are potential risks to macro factors that may affect an issuer’s ability to repay its debt.
Different ESG factors will present greater risks over different time periods. In the short term, investors face a greater threat from the fallout of low-frequency, high-impact events such as extreme weather or industrial disasters. Beyond 15 years, ESG trends, such as demographic changes and climate change, are likely to have a significant impact on bond yields.
“Some environmental litigation risk could be ten years down the road. That’s an example of where an ESG-related headline could present an attractive buying opportunity in a shortdated bond, say three to five years, but discourage us from going out to ten years in a name.”
Cathy Roy, Calvert Investments
Investors stand to benefit by considering these factors as an integral part of their investment philosophy when making decisions on asset allocation, portfolio construction and ongoing investment management.
The fundamental elements of issuer analysis remain the same for all types of issuers.
- Analyse the issuer’s exposure to material risks and their capacity to manage those risks.
- Understand the financial implications of those risks materialising.
- Price the risk and determine whether the bond represents good investment value.
ESG analysis can therefore help investors to form an opinion of the value of a bond, identify improving credit stories or differentiate bonds with seemingly similar financial profiles. (ESG factors may also influence other aspects of fixed income analysis such as interest rate risks.)
Persistently low ESG scores due to significant risks may ultimately lead an investor to divest from a bond or decline future issues. As an alternative to divestment, a portfolio manager may use ESG analysis to inform their weighting decisions, tilting these in favour of companies that represent better value according to ESG analysis.
“Our relative value framework is predicated upon our belief that ESG factors are most influential on spread performance for companies that exhibit combined outlier fundamental and ESG characteristics, i.e., an overweight stance on companies with both an improving fundamental and ESG profile, and an underweight stance on companies with both a deteriorating fundamental and ESG profile. Therefore, we believe that ESG factors may not affect spread performance when a company’s strong (weak) ESG profile is juxtaposed against a weak (strong) fundamental profile.”
Calvert Investments, Transparency Report 2014
Risk flagging, watch lists and traffic light systems
Red flags, watch lists or traffic light systems are all effective ways of quickly and effectively highlighting particular ESG-related concerns to investment staff. Issuers with a combined ESG score (or specific ESG indicator) below a pre-set threshold are allocated a red flag, or stop, in the investment process to ensure that credit analysts or portfolio managers are aware of the risks involved. The system works both ways; analysts may identify a bond they consider undervalued given the issuer’s exceptional ESG score, although the focus should primarily be on risk. Ultimately, red flags may prompt a number of different outcomes. At a minimum, they should encourage deeper analysis of the reasons behind a particular concern or failing. Analysts may then be required to justify their preference for that issuer. Poor ESG scores may prompt investors to engage an issuer for more information or to reduce their overall credit rating. This may cause managers to change their opinion on pricing and, ultimately, buy or sell a bond and adjust its weighting in a portfolio. All of these approaches ensure that investors consider ESG systematically rather than in an ad hoc fashion.
Issuer reporting and bond documentation
Debt prospectuses open with ‘Introductions and Warnings’ and also include a ‘Risk Factors’ section in which the issuer lists possible risks to creditworthiness. These statements vary across sectors and regions, but it is very rare that they mention ESG-related risks in any jurisdiction. Some companies, particularly energy utilities, include risks relating to carbon regulation. Items where ESG factors may be relevant to an issuer include risks arising from the volatility of commodity prices, regulatory and political risks, legal risks, and risks to continuity of business activities.
Bond covenants protect the interests of the borrower and lender in any dispute about terms. When an issuer violates a bond covenant, it is considered to be in technical default, which will most likely affect future credit ratings. It is common for covenants to specify that the issuer provides regular financial statements to the investor and places limits on the proportion of debt it holds relative to income. It is feasible that bond covenants could also include clauses requiring an issuer to conform to certain norms, such as following the Global Compact standards.
Passive fixed income funds play an increasingly important role in institutional portfolios, but very little research has been done on the role of ESG in passive fixed income funds. This is an important subject for future consideration. Below are some initial considerations.
- Investors require new indices to manage passive ESG funds that incorporate ESG analysis. As investor understanding of ESG or sustainability varies and is subjective, some investors may not agree with methodologies applied in indices that integrate ESG factors.
- Aggregated indices that apply negative screens will understandably be considered as niche because accepted ethical values and social norms vary by sector.
- ESG-tilted indices will help fixed income investors develop passive funds that integrate ESG, focusing on environmental and social themes.
- One key opportunity for fixed income investors is to replicate an index in a passive fashion while making weighting changes to reduce overall ESG risk in a portfolio.
Asset owner considerations
- Assess ESG risk concentration at portfolio and fund levels (via investment managers).
- Review manager integration policy and approach: Are analysts and PMs incentivised to integrate ESG? Is their ESG data verified? Do they have sufficient resource for this?
- Use ESG information to inform asset allocation and diversify bond portfolios. Simple ESG ratings will help asset owners to spread risk across fixed income portfolios to optimise financial, environmental and social value.
- Engage issuers together with investment managers to enhance transparency and gain ESG information.
- Consider exposure to ESG risks via passive bond funds. Can investors actively replicate these with ESG-adjusted portfolio weights to mitigate major risks?
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Integrating ESG factors into issuer analysis