Interest in incorporating environmental, social and governance (ESG) considerations into investment decisions has increased substantially over recent years and this is now moving beyond the more traditional domain of the equity markets and into fixed income. This paper examines the drivers behind this trend, what ESG integration means for fixed income investors, how the ESG corporate universe compares with a traditional one, and why investing in green bonds is not as simple as one may think.
Fixed income is evolving towards ESG integration
Historically, the integration of sustainability considerations in finance has been more prevalent in listed equities than in fixed income. This lag in investors implementing ESG considerations within their fixed income investment processes has been due to a variety of reasons. These include the role of ESG in credit ratings, the limited availability of sustainability indices against which to benchmark performance, and the challenges in engaging with issuers. At UBS Asset Management (UBS-AM), we observe that this is now quickly changing.
Investor interest in broad ESG investments has been rising steadily over the past three decades. This is now being underpinned by the clear support of policymakers. In our opinion, the next significant step is the integration of sustainability considerations into the overall credit assessment. This moves sustainability beyond a niche investing activity with significant implications for mainstream investors who are looking to implement sustainability in their credit portfolios.
Unique challenges to addressing ESG in fixed income
The key difference between fixed income and equity investors is the fixed income orientation towards managing downside default risk and the equity orientation towards upside appreciation. However, at the more granular level of analysis, the range of considerations which must be incorporated and accounted for is wide in fixed income.
What impact does ESG investing have for all fixed income investors?
Until recently, only a few investors and asset managers focused on sustainability-themed investments and most market participants did not consider ESG as an impactful factor in their investment process. Despite rising interest, many market participants still do not believe that sustainability factors have a direct effect on their fixed income strategies. However, we believe the market is evolving rapidly and at UBS-AM, we are not only looking to offer a wide range of sustainable strategies, but actually are shifting the investment analysis and strategy towards sustainability.
Sustainable Investing (SI) approaches - an overview
ESG integration into the investment process starting from credit research is the foundation for sustainable themed investing. This approach entails incorporating ESG factors and considerations into the fundamental credit analysis and provides deeper risk analysis, adding another dimension.
The more sophisticated approach to sustainable investing is sustainability-focused strategies. These types of strategies follow a best-in-class or positive screening approach, where portfolio managers invest in issuers with high sustainability ratings and/or profiles. On a passive basis, this approach can be implemented via ESG-compliant indices. Investors are faced with a growing number of indices with very different rules for index construction.
The biggest impact fixed income investors can achieve is via investing in securities that have a direct link to a sustainable project, such as green bonds where the proceeds are used to fund specific sustainable projects. Another alternative would be to invest in asset-backed securities where the proceeds directly finance sustainable investments.
Integrating ESG: Focusing on fundamentals
The UN Principles for Responsible Investment (PRI) define integration as “the analysis of all material factors in investment analysis and investment decisions, including environmental, social and governance (ESG) factors.” Unfortunately, the concept of “integration” of sustainability is, in our view, often used too broadly in the industry to refer merely to the application of sustainability data or ratings in the investment process.
At UBS-AM, we have taken the decision that ESG integration is strongest when the credit analysts sit at the heart of it. Our credit analysts are at the center of ESG integration in fixed income because we believe they are best placed to make use of their in-depth knowledge of issuers and experience in fundamental analysis to provide the context in which to consider sustainability issues. They aggregate quantitative and qualitative data, consider its relevance and materiality, put it into an appropriate recommendation framework, and then also make judgements based on sometimes incomplete and imperfect information. Analyzing ESG issues requires the same skills, albeit from a different starting point, a different set of conditions and sometimes divergent conclusions.
Crucially though, UBS-AM credit analysts make forward-looking judgements. This applies as much to ESG issues as to financial ones, and as such, distinguishes their work from pure ESG data gathering or scoring discussed earlier in this paper. The important pillars of ESG integration in our credit research process are:
Materiality analysis: The integration process is based on UBS-AM’s materiality analysis, which was developed by our sustainable investment research team working in collaboration with our credit analysts.
Fundamental analysis: Based on the materiality framework to focus on the most material issues, the credit analysts then assess a set of key ESG strengths and weaknesses for each issuer. Crucially, analysts focus their research and analysis on whether and to what extent the most material sustainability issues impact the fundamental creditworthiness and risk profile of the issuer.
Capturing outcomes: The outcomes of our credit analysis are captured via our UBS ESG score which, put simply, requires analysts to make three key decisions for individual issuers:
- What is the material impact of sustainability issues on the fundamental credit assessment?
- What is the likely future direction of the ESG credit score?
- Does the ESG analysis lead to a change in credit opinion?
By systematically integrating ESG factors across our fixed income platform, we are moving a step closer to our stated ambition of broad sustainability integration across all asset classes.
How does an ESG corporate universe compare with a traditional one?
When Bloomberg Barclays started their collaboration with MSCI to develop a suite of ESG indices in 2013, interest from investors was quite limited. Although most asset managers and investors welcomed the initiative, the actual flows to track these indices were not significant. At UBS Asset Management, we engaged with the providers early on to better understand their approach and process for index construction to be able to assess the impact and potential result on portfolios as and when our clients start investing. In July 2015, in response to demand from our clients, we launched the UBS ETF – Bloomberg Barclays MSCI US Liquid Corporate Sustainable, hedged to different currencies as the first mover in Europe.
We believe it is always essential to analyze the index universe before investing in order to understand the index construction methodology, which is also valid for ESG indices. Fixed income indices have different characteristics to equity indices, driven by the nature of the asset class. Fixed income indices contain higher numbers of securities, as one company typically has one stock listed but many outstanding bond issues. Fixed income indices also tend to be more dynamic and have higher turnover. As an indication, approximately 30% of the global bond index changes annually, compared to 3% of the global equity index. If additional rules and constraints are added, such as ESG considerations, the turnover will likely increase further, therefore ESG indices tend to have higher turnover than standard indices. Turnover is an important consideration for fixed income investors, as it is the main driver of transaction costs represented by the bid-ask spread and tends to be higher than equity commissions.
Why green bonds are not the silver bullet
Although the green bond market has grown exponentially in recent years with interest from sustainability-focused investors as well as traditional investors, it is still quite small in size. The Green Bond Index has 304 issues, whereas the Bloomberg Barclays Global Aggregate Index has 22,742 (as of the end of December 2018). Although the market values are different, we still believe that the indices are comparable from a risk-return perspective given the global footprint and the types of issuers included. Both indices are of similar duration, about seven years, but Green Bond Index yield is ~0.20% lower. This should take into consideration that the Green Bond Index is also the only global index where the EUR component (62%) is larger than USD (27%). By comparison the Global Aggregate comprises 25% and 45% respectively.
Beside the standard bond index comparison, we need to be aware that not every newly-issued green bond will be included in the universe as there are additional index inclusion criteria; MSCI adds a filter to ensure a certain quality of “green” is achieved.
At the same time, the lack of standardization of the Green certificates available to companies makes it hard to guarantee the quality of the green bond. For that reason, investors should be extra careful when investing in funds, which are labelled “Green” but do not have an additional screening in place. The market will surely continue to evolve very quickly and market participants, whether dedicated green bond investors or not, will need to actively participate.
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