ESG has been a theme in equities for many years. Why is it now a growing trend in fixed income?
Fixed income has traditionally been used for its ability to manage downside risk while generating income and, in general, it continues to play a diversification role in asset allocation. The fixed income investor base is growing as both institutional investors, such as pension plans, and an increasing number of retail investors, such as retirees and everyday savers, perceive greater volatility within equity markets and allocate more of their capital to fixed income.
At the same time, market participants such as asset managers, asset owners, regulatory agencies and policymakers are increasingly thinking about ESG issues beyond just the implications for equity shareholders. In addition, more investors are seeking to use their capital to have a positive social or environmental impact, which involves a greater degree of ESG integration.
In light of this, and given that fixed income markets are significantly larger than equity markets, it is clear why ESG is becoming an increasingly important part of fixed income investing.
How do you approach incorporating ESG issues into fixed income analysis?
Our investment approach has always focused on identifying companies and issuers with sustainable, long-term competitive advantages. As investors, we need to take into account all factors that can affect the viability of our investments through multi-year business cycles and ever-evolving macro environments. As such, we believe that the integration of ESG factors into our research is essential, as these issues often affect the long-term sustainability of cash flows for corporations and other issuers.
When evaluating corporate bonds, integrating ESG issues into our fundamental analysis of the issuer's credit and leverage profile is critical. ESG analysis involves understanding issues that are typically nonfinancial in nature, such as environmental impacts, employee well-being, supply chain management, product safety and workforce diversity. In the short term, shocks to these factors can affect cash flows and the ability to pay interest to debt holders. In the long term, they can harm corporate culture and impact operating models, which can lead to the erosion of revenue generation and, ultimately, profitability.
While governance is widely considered the most prominent ESG factor affecting various fixed income sectors including corporate, sovereign and municipal bonds; environmental and social factors must also be considered in any analysis. For instance, the deterioration of social or environmental factors can influence the political stability or business climate of a particular country. Therefore, we evaluate social factors, such as inequality, and environmental considerations, such as air quality and water stress, along with a country's governance practices, such as the independence of institutions, rule of law and enforcement of contracts.
Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity.
Please keep in mind that a sustainable investing approach does not guarantee positive results.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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