ESG integration in fixed income
Francis Condon, Senior Sustainable Investment Research Analyst, and Christopher Greenwald, Head of SI Research, Sustainable and Impact
Historically, investors have been more likely to integrate sustainability considerations within equity than fixed income strategies. There are a number of reasons for this: the role of ESG in credit ratings, a shortage of ESG indices against which to benchmark performance and challenges in engaging with issuers. But that picture is changing fast.
More and more investors are expressing an interest in ESG investing beyond equities, supported by initiatives from policy makers, such as the European Commission's High-Level Expert Group on Sustainable Finance. Given bonds form a key constituent of institutional portfolios it is hardly surprising that investors are looking into integrating ESG principles to fixed income investments, particularly as regulatory and fiduciary pressures increase.
Several factors have made ESG integration into fixed income easier. ESG data and ratings are now available for almost all investment grade credit, and for many high yield issuers. Several important innovations in fixed income have also occurred, allowing investors to allocate more private capital to sustainable fixed income instruments. These innovations include the rise of green bonds, the emergence of social bonds, and unique collaborations, such as that between the World Bank and UBS to provide sustainable investment alternatives to high grade fixed income.
The next significant step in our view is the integration of sustainability considerations into the overall credit assessment, and the important implications that carries for mainstream investors looking to apply sustainability in their credit portfolios.
Integrating ESG: The Limitations of ESG Ratings
All too often in our view, 'integration' of sustainability simply refers to the application of sustainability data or ratings to the investment process. But we think this reflects three crucial misunderstandings around the role of third-party sustainability data in relation to sustainability integration.
First is the belief that applying ESG ratings based on some form of screening equates to sustainability integration. Undoubtedly the data sets from large ESG providers are invaluable for the finance industry, and the challenges of collecting and presenting the underlying data in a consistent, usable format are great. However, that type of data does not comprise investment analysis. By their very nature they are based on historic information and events, reflecting what has happened rather than what might happen in the future.
Second, ratings providers serve a wide range of parties and topics, so their frameworks are broad; too broad in our view to be immediately applicable to the investment process. Furthermore, their sustainability information tends not to distinguish between fixed income and equity applicability. Although some overlap exists, fixed income investors are more concerned with downside risk, whereas equity investors tend to focus on upside growth potential.
Third and most important, in our view, is the fact that the assessment of sustainability ratings is separated from the actual financial analysis of a company. The data providers work independently of the investment process so do not cover the impact of material sustainability issues on the actual financial assessment. While sustainability ratings are important, to be truly meaningful, we argue the credit analysts and portfolio managers need to apply those ratings to their own financial credit assessment.
Hence our approach reflects our core belief: ESG integration is strongest when the credit analysts sit at the heart of it. They are best placed to use their in-depth knowledge of issuers, and experience in fundamental analysis, to provide the context in which to consider sustainability issues. It is that same skill set which they use to analyze ESG factors. Most crucially, the analysts make forward-looking judgments – something which applies as much to ESG issues as to financial ones. By having analysts own their understanding of sustainability issues, we expect ESG integration to deepen further still.
Collaboration is vital. Our sustainability investment research team provides close support to the credit analysts, advising on materiality and timing of relevant ESG issues across the full range of sustainability factors. Through this ongoing dialogue, we can address questions about the materiality of a topic, such as how well an issuer manages its risks, how different levels of materiality or the timing of an ESG issue will likely develop, and ultimately, will the ESG issues impact the credit assessment? Are they significant enough to become a key consideration in the future development of the issuer's credit worthiness, and to what extent does the ESG analysis change the credit opinion? These are key questions the sustainability analysts work with the credit analysts to determine.
The approach described so far forms the bottom-up assessment, carried out primarily by the credit analysts. There is one further, important step which our sustainable investment research team carries out and that is to provide a top-down context for ESG issues. They do this by assessing cross-sectoral topics from the perspective of overall credit impact, thereby supporting credit analysts in their assessments, and portfolio managers wanting to position their strategies appropriately.
We believe that ESG analysis by the credit analysts provides an opportunity to pursue a deeper level of integration, one which is materially-focused, forward-looking and concentrated on the implications of sustainability for credit risks.
Our aim is to remain at the forefront of this movement, developing innovative new strategies and solutions to answer the challenges our clients face.