Joshua Kendall believes more focus needs to be placed on ESG in fixed income.
- While equity investors have received high levels of service with regards to ESG analysis there has been less on the fixed income side
- Fixed income investors should consider a wide range of ESG factors
- Academic research suggests corporations with better ESG ratings typically enjoy a lower cost of financing and higher credit ratings
Lending money to Abengoa, a Spanish multinational focused on renewable energy, was an attractive opportunity for many European investors. When it issued its first green bonds in 2014, investors lent more than €500m (£435.1m).
But within weeks, uncertainty over the company's financial position led the price of its bonds to plummet.
Hundreds of millions of euros have been wiped off the value of the company's green bonds and shares. Today, they are worth a fraction of their original price, and the company is negotiating new terms with its lenders. This is a nightmare scenario for fixed income investors, but using environmental, social and governance (ESG) analysis may have helped investors avoid this situation.
Unlike equity investors, bondholders have less direct influence over an issuer's strategy and governance. Risk management to avoid the risk of default is central. This means that ESG risk analysis should be of central concern for fixed income investors.
In the case of Abengoa, when its green bonds were issued in 2014, Insight's analysts believed the company's complex financial structure, with aggressive and opaque accounting, presented material risks. We were also concerned about its corporate governance practices, which were rated worst-in-class, and raised concerns directly with the company. On the basis of this analysis, Insight avoided the issue, and our credit portfolios avoided the resulting losses.
This is a prime example of the significance of ESG risk analysis for fixed income investors.
Integrating ESG analysis within fixed income investment
Equity investors have long received high levels of service in terms of ESG analysis. It is a mature industry: as an example, MSCI offers over 120 ESG indices.
By comparison, credit investors have less support, though the industry is seeing positive developments. Six leading credit ratings agencies have recently joined an initiative to look at ESG factors in a more systematic way, backed by over 100 investors managing US$16trn (£12.4trn) of assets.
Indices provide useful benchmarks for investors and rating agency involvement is to be warmly welcomed, but it seems clear that fixed income investors will benefit if their fixed income managers can take ESG factors into account within their investment analysis – as the Abengoa example demonstrates.
When evaluating the likelihood of future changes in a company's credit rating and the potential for a sudden change in credit quality, our analysts conduct a fundamental review of a company's financial risk, in particular its cash flow, revenue and profitability.
Alongside other key business risks, we consider a wide range of ESG factors (see box) which informs our investment decision and ESG risk scores play an important role in assigning a credit rating that indicates the relative risk of default loss.
Different approaches to ESG in fixed income
Beyond analysis of ESG risks as a crucial element of effective risk management, fixed income investors may decide to exclude investments in certain sectors, or in issuers that fail to meet minimum standards with regard to ESG factors. Others may opt for a "best-in-class" approach, with larger allocations to issues which score well on ESG matters.
Analysis suggests that excluding certain fixed income investments from a portfolio may not have a material impact on performance (see table). This may be positive or negative for investors, depending on why they are excluding certain issuers or sectors from their portfolios.
Table 1: Portfolio exclusions do not necessarily have a material impact on performance
Source: Insight Investment. Traditional screens exclude tobacco, alcohol and arms companies from the index return.
With regard to best-in-class portfolios, academic research suggests there may be benefits in terms of risk exposure, with findings showing that corporations with better ESG ratings typically enjoy a lower cost of financing and higher credit ratings, along with less company-specific risk relative to their counterparts. Whether these apply to specific portfolios will depend on their parameters.
Investors are increasingly convinced that incorporating ESG risks is crucial for effective risk management in fixed income portfolios. While it can help reduce default risk, it can help to assess whether the yield offered by an issue is appropriate given the underlying risks. Pension funds should therefore encourage their fixed income managers to adopt a holistic approach to risk management that incorporates such analysis.
Box out: ESG risk indicators relevant for credit analysis
ESG factors include a wide range of issues, some of which are listed below. Examples of companies materially affected by the various factors are included.
• Board accountability and effectiveness (Petrobras)
• Executive pay policy and oversight (Mondelez)
• Ownership structure and control (Alibaba)
• Integrity of accounting practices (Toshiba)
• Bribery and corruption (BASF)
• Health and safety (Samarco)
• Employee relations (Barrick Gold)
• Community impact (Duke Energy)
• Product safety (Mylan)
• Product sourcing (PG&E Corporation)
• Climate change risks and vulnerability (RWE)
• Pollution and waste (Canadian Natural Resources)
• Biodiversity and land impact (Freeport-McMoRan)
• Carbon emissions (Sasol)
• Water usage (Mining companies)
• Securities class actions (SunEdison)
• Litigation (Volkswagen)
• Transactions, including M&A (Pharmaceutical companies)
• Aggressive decision-making (IBM)
• Basic financial disclosures (Brussels Airport) < /div>
Joshua Kendall is ESG analyst for Insight Investment
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