Where is the ESG fixed income sweet spot?
ESG investing surged in popularity last year as the coronavirus pandemic shone a spotlight on a wide range of environmental, social and governance risks. However, both demand and product offering have until now clustered around the equity space, while the choice available to fixed income investors has been limited.
This, however, is in the process of changing. Strong investor demand for better choice of ESG fixed income products has led to extensive research and data collection in the asset class. In 2021, the industry finds itself at a tipping point when it comes to investing in bonds sustainably.
The road to this point has been bumpy, with a number of stumbling blocks making it harder to implement a ‘true’ style of ESG investing in the fixed income space.
One of the biggest issues is that fixed income investors do not get a seat at company AGMs, and are therefore unable to vote. At the same time, the availability of data in the fixed income space is much less transparent than in equities; it is estimated that at least a third of the bond investment universe is not currently covered by publicly available data.
While being challenging, true ESG investing in this asset class is by no means impossible and does not have to be more difficult than in the stock market, according to Graeme Anderson, partner and portfolio manager at TwentyFour Asset Management. The key, he says, is to have the right building blocks, meaning the underlying data and research to inform investment decisions.
This data is constantly improving and has benefitted from the adoption of a formalised approach that drills down deeper into ESG issues. Anderson points out that some form of ESG consideration has been inherent in fixed income investing for decades, particularly on the governance side.
“The big change that we have seen is that we are now conducting more formal analysis of ESG,” he says. “Formalising it has made it much more powerful and it is spreading out to look at more environmental and social issues.”
While third-party data availability is improving, TwentyFour’s view is that relying on these ratings alone for investment decisions is not good enough and cannot be considered true ESG investing.
“The ESG investment world is full of badges and individuals and firms that have signed up to different types of accreditation. The next thing will probably be the creation of global ESG ratings. But do any of these really reveal how ESG metrics are being implemented within the company itself?”
To create truly sustainable fixed income portfolios, Anderson thinks it is necessary to put in the work to gain a deep understanding of each individual company yourself.
This is in part because the data coming out of large corporations may look good on the face of it, since these firms “have teams and teams of marketing people and analysts” and can therefore “profile themselves very well on an ESG basis because they know the questions and the answers they should be giving,” says Anderson. Drilling down deeper, however, could - and often does - yield drastically different insights.
Against this backdrop, Anderson believes a hands-on approach to ESG fixed income is unavoidable. This includes both granular quantitative and qualitative research, positive/negative screening and regular engagement with issuers. This approach has helped TwentyFour create alpha in its sustainable portfolios relative to its peers.
For Anderson the need to invest in ESG as a concept goes deeper than returns. Much like in the equity universe, engagement is a key tool for bond investors in trying to effect positive change. Far from having no voice when it comes to company resolutions, fixed income investors are in fact often in pole position when it comes to pushing for positive change. Most companies require regular debt refinancing and are therefore forced to turn to the bond market and come face-to-face with their capital providers multiple times a year.
However, Anderson believes this engagement must be targeted and issue specific: “You have to engage where you think you can be effective. Ultimately, we want better societal outcomes. So if you come to the conclusion that you really believe a company is on a path to a better sustainable future, then capital markets should support that company, not shun it because of where it is today.”
In fact, according to Chris Bowie, also a partner and portfolio manager at the firm, in his experience the best-performing companies both in terms of alpha and ESG are likely to be those that score relatively poorly on ESG metrics today but are committed to positive change. Ultimately, you would expect them to see a fall in their cost of capital, which would lead to a capital gain from their bonds.
“One of the best examples is Scottish and Southern,” Bowie says. “Five years ago, most of their electricity came from coal; in 2020 they exited coal for good. So they have really cleaned up their operation.”
In addition, Anderson says engagement has been effective in driving better reporting from issuers. For example, more and more issuers are reporting CO₂ intensity data, having realised this is important for their investors.
As reporting standards and data improve, ESG investing in fixed income clearly looks to only be going in one direction. But as demand grows, so do investors’ expectations. As such, both Bowie and Anderson say a sophisticated and thorough approach will be paramount for those wanting to stay in the game.
The most material impact of this demand will be at a fund management level, says Anderson, though he notes issuers are also becoming more proactive: “We have now got two sustainable funds at TwentyFour and it is clear that interest from asset owners is growing rapidly, and this reflects their increased understanding of the nuances of a sustainable fund.
“From the issuers’ point of view, they are receiving more ESG-focused questions from us and they can no longer avoid them. We have seen a growing number of issuers stating that if we can provide a premium on a bond issue, they will link capital to green projects or a commitment to cutting CO2 emissions over time. If they fail, there will be a step-up on the coupon.”
As demand for companies with the highest ESG scores reaches a tipping point, Anderson predicts some ‘sin’ industries, such as tobacco and alcohol, could reach a tipping point where they become cheap enough to compensate investors for taking on ESG risks. While a sustainable fund may not be able to take advantage of this, ESG-integrated vehicles likely could. He also sees companies in these industries potentially exiting public markets and looking for funding in private markets, as investors increasingly shun funds with exposure to ‘sin’ industries.
The green bond market reported annual growth of 49% in 2019, and Anderson expects this trend to continue as demand for green, sustainable and social bonds grows. However, he highlights that in his view the regulation and monitoring of this space so far has been inadequate, while the low levels of yield these bonds tend to offer often fail to make them an attractive investment at this stage.
While the US has traditionally lagged behind Europe in ESG and sustainable investing, Anderson sees this changing and believes the change could be “huge”. A big driver for this has been the election of Joe Biden as US President, who has already signalled his commitment to the ESG agenda by rejoining the Paris Agreement.
Anderson expects ESG data availability in fixed income to improve over time, with stricter standards and definitions being introduced. However, he warns against over-reliance on industry ratings and “badges”, which are in danger of being a simple box-ticking exercise.
Sophisticated investors, especially pension funds, are already putting more emphasis on detailed reporting of ESG and sustainability metrics and showing more interest in fully sustainable funds over pure ESG integration models, and Anderson expects this trend to grow.
To be truly sustainable, funds need an active approach.