By Carmen Nuzzo, Head of Fixed Income, the PRI
Factors such as climate change, resource depletion and board gender diversity are earning a firmer place on the agenda of fixed income investors and credit rating agencies (CRAs) globally. Given the weight that CRAs carry in fixed income markets, this can give further impetus to ESG investment practices.
Although the basic tenet of assessing credit risk still holds, the global fixed income community is increasingly seeking ways to systematically factor in sustainability considerations when allocating capital and managing risks.
Admittedly, governance has traditionally featured in credit risk analysis, as it tends to be assessed as part of the investor and CRA due diligence process. However, corporate scandals which have triggered sizeable financial losses in recent years, and the devastating effects of the global financial crisis, are stark reminders of why a lack of proper oversight, transparency and accountability can negatively affect fixed income market pricing and volatility – and ultimately financial stability.
Beyond governance, the business case for integrating ESG factors is increasingly compelling as the effects of climate change are more visible and investors begin to grasp how social factors – such as workforce diversity, labour conditions and employee development – can impact a company’s financial performance and reputation.
Since many fixed income investors buy bonds for capital preservation, it is critical that – where material – these factors are systematically included in bond valuations. This is particularly pressing for insurers and pension funds, which own large quantities of fixed income securities for asset/liability management and have a fiduciary duty to their policy holders and beneficiaries.
Beyond stewardship and risk management, sophisticated investors are learning how to model ESG factors to spot market mispricing and opportunities – some are creating internal proprietary ESG indicators to help with bond valuations. They also expect greater clarity from CRAs to understand what is already factored in their rating opinions and avoid double counting.
Because of their unique role in the fixed income market, CRAs play a crucial part in promoting ESG integration in credit risk analysis. Even if credit opinions are just one element of an investor’s assessment of creditworthiness, they are closely monitored by market participants that may trade on potential upgrades or downgrades. Furthermore, credit ratings often define or limit investment mandates. They are used for a range of other market applications – such as the eligibility of collateral or credit enhancement in structured finance transactions – and by a variety of market players, including central banks.
The PRI has been working with investors and CRAs since the launch of the ESG in Credit Risk and Ratings Initiative in 2016 to promote understanding of practices, identify gaps in the consideration of ESG factors in credit risk analysis, and find ways to address those gaps. This work is documented in the report trilogy titled Shifting perceptions: ESG, credit risk and ratings.
What the investor-CRA dialogue has highlighted is that ESG consideration in credit risk analysis is still not addressed consistently and systematically by all fixed income market participants. Nonetheless, it has brought to light that:
- Positive developments are gaining momentum, with many investors and CRAs intensifying their focus on analytical tools and resources, as well as launching dedicated ESG web pages and boosting their transparency efforts to explain how ESG factors feature in their analysis.
- ESG signals are now being used to spot investment opportunities as well as manage downside risks.
- Fixed income investment and credit ratings have different objectives. Whereas a credit rating will only include ESG factors if material to credit risk, investors looking for guidance on ESG factors in a fixed income investment may also use standalone ESG scores and assessments. The latter tend to focus on the overall financial performance of a bond or of its issuer, not just default probability.
The 20 forums organised by the PRI for credit practitioners around the world over the past two years have revealed confusion among market players in terms of what it means to consider ESG factors in credit ratings and what are now commonly known as ESG or sustainability ratings. These scores, rankings or assessments measure how well security issuers perform on ESG factors relative to their peers. But while they can help investors make more informed decisions, they don’t necessarily capture the implications of ESG factors on issuers’ balance sheets and hence their relative risk of default. In other words, they are complementary but distinct products from credit ratings. Unlike credit ratings, they are also unregulated.
The investor-CRA dialogue has also helped to highlight that ESG dynamics in fixed income differ from considerations in equity markets. For example, the potential materiality of ESG factors varies depending on the financial strength of the entity that issues a fixed income instrument, as well as the type of issuer (sovereign or corporate), its sector and the maturity and structure of a bond. Finally, these considerations cannot be separated from other factors, such as inflation developments, prospective central bank policy interest rate changes, liquidity conditions and foreign exchange movements.
Albeit slowly, there is a growing recognition that ESG factors may alter collateral value and recovery rate estimates. What is also increasingly apparent is the need to make different loss assumptions if assets become stranded because of climate-related risks, new regulations, technological developments, changing social norms, and in the interpretation of existing legislation with regards to fiduciary duty.
However, embedding ESG integration more systematically in credit risk analysis will require fundamental institutional changes. This raises questions around how credit analysts should be incentivised and equipped with the resources required to broaden their analysis beyond traditional financial variables. It also raises questions around the role of senior management in promoting the systematic and transparent integration of ESG factors in credit risk analysis. And what role should regulators play, if any? Finally, how can investors and CRAs help to reinforce the need for enhanced data disclosure by issuers?
If you want to be part of the ESG in Credit Risk and Ratings Initiative, currently supported by over 150 institutional investors (with about $30 trillion in AUM) and 19 CRAs, please contact us.
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