Why BoE Hiking First May Be Best for Bonds
As fixed income investors we have always told our clients that when you buy a bond with a buy and hold mentality, the best outcome is to receive your coupon payments and your principal back at maturity; this statement alone shows there is a symbiotic relationship between fixed income investing and Environmental, Social and Governance (ESG) considerations.
By definition, we need to invest in companies whose business model is sustainable as this ultimately drives the ability of such companies to pay coupons and repay principal. A company making short run abnormal profits because of a socially predatory business model or poor governance runs the risk of being regulated, litigated against or publicly shamed. The company may provide an equity buyer a suitable return for the risk they are taking, but that risk is not appropriate for a long term bondholder with a defined return target.
With environmental and social considerations rightly coming to the fore, governance at times seems like the forgotten element of ESG among investor and media discourse. While, the EU’s Sustainable Finance Disclosure Regulation (SFDR), requires managers to implicitly consider governance factors, it only requires screening processes focussed on either social or environmental metrics (or both). Emphasising these metrics might push some managers to actively consider both more readily, we would argue that astute evaluation of a firm’s governance remains a crucial part of fixed income analysis, and we regard a holistic view that includes governance as more beneficial.
Likewise, according to a 2016 study from Barclays1, a divergence in priority appears between some asset managers and their clients regarding the relative importance of the three ESG components. Clients regard environmental factors as the most important, while governance is top of the list for bond managers. Moreover, the same study showed that bonds with higher governance scores tended to have fewer downgrades and better outperformance, during the period from August 2009 until April 2016, than those with lower scores, validating the emphasis bond managers have historically placed upon effective governance.
As a bond manager focused on active engagement, these findings reflect our own. In our experience, companies with strong governance tend to have robust environmental and social policies. It is questionable how much regard a company with weak governance, despite possessing apparently robust policies, can give to environmental and social factors.
Tesla provides a pertinent example of the issue. Most people would agree that electric vehicles have the potential to be a significant force for good in helping to combat CO2 emissions, hence Tesla scores highly in some models. However, leaving aside considerations around energy inputs into the car manufacturing process, Tesla’s governance structure appears problematic. With so much power in Elon Musk’s hands, will Tesla’s structure sustainably ensure the best treatment of stakeholders? Those governance concerns are one of the reasons why some databases and investors score Tesla poorly.
Therefore, while E and S tend to make more headlines than G, governance concerns should remain a fundamental building block in the move to a sustainable fixed income investment universe.
As we finally emerge from the mire of the pandemic, one clear lesson for investors is the benefit of effective governance in a crisis. Those management boards that tempered short term shareholder expectations helped ensure the health and longevity of their businesses amid a period of unforeseeable market strain. Moreover, maintaining prudent balance sheets and bolstering liquidity allowed those same firms to capitalise as economies began to reopen.
As a result, rather than occupying a tertiary position in the ESG hierarchy, we expect governance considerations to remain at the forefront of investors’ analysis as we move.
1. Source: Sustainable investing and bond returns, Barclays Investment Bank https://www.investmentbank.barclays.com/content/dam/barclaysmicrosites/ibpublic/documents/our-insights/esg/barclays-sustainable-investing-and-bond-returns-3.6mb.pdf