BMO Global Asset Management believes in the importance of responsible investment (RI) where asset owners have a privilege and trusted position as stewards of capital, which provides both influence and responsibility. The relevance of fixed income instruments from a responsible perspective has long been identified, but the spotlight towards RI has been on equities and the impact of environmental, social and governance (ESG) factors on shareholder value. To shed light and bring more relevance on RI in the fixed income space, BMO introduces their approach and describes why and how they incorporate ESG factors into their corporate fixed income investing and engagement. The report also looks at the growing sustainable bonds market and how they are aligning investors with sustainability goals.

The guide highlights the impact of ESG factors towards an issuer’s credit risk, and relevance to creditors. Financial, operational, and reputational risks linked to ESG factors can materially affect a company’s ability to generate stable cash flows to honour its obligations. Compared to equity investors, creditors have limited upside potential in investment returns and tend to be more focused on the downside risk; a good incentive to incorporate ESG factors into the credit approach.

The guide provides some examples of ESG risks that could affect a company’s credit risk, including:

• Environmental risks: Litigation, clean up and reputational risks associated with environmental pollution.
• Social risks: Involvement in human rights violations.
• Governance risks: Effectiveness of board oversight of company management, providing appropriate checks and balances to prevent abuse.

BMO factor ESG issues through a dual approach; ESG integration and engagement. Integration sees BMO incorporate ESG factors into its credit scoring methodology. It does this by assigning ESG factors to form part of the issuers ‘business risk assessment’ which, next to financial risk and sovereign risk, contributes to the overall credit quality of the issuer. Here, analysts assign a current credit score to get an overall credit profile, as well as assign a future credit score to identify the likely direction of credit quality. Commitment or engagement by the issuer can also lead to a higher score. The score is used to assess relative value where companies with low credit scores may require a higher yield or spread to compensate for higher risk.

BMO uses engagement to encourage companies towards best practice and management of ESG issues. While engagement has previously been seen as an approach for equity investors, the need for continued refinancing means that engagement has been relatively accepted by issuers.

The guide highlights the rapid growth in the sustainability bond market and how these new investment products are being used to tackle some of the most pressing societal and environmental challenges of our time. Now investors are able to seek both returns and a positive impact. However, it is noted this has its drawbacks as these bonds open the door to greenwashing where issuers can create a misrepresentation of their sustainability profile.

While the integration of ESG factors in fixed income strategies has come a long way, there is more to come. Constant improvements in ESG data, developments in company reporting as well as investor participation will see a much larger focus of ESG in the space of fixed income.

1. While the spotlight in responsible investment has been on equities, and the impact of environmental, social and governance (ESG) factors on shareholder value. The relevance of fixed income instruments for a responsible investment perspective has received little attention and the role of creditors and bondholders can have a large influence in driving sustainability in the financial markets.
2. Financial, operational and reputational risks linked to ESG factors can materially affect a company’s ability to generate stable cash flows to honour its financial obligations. Therefore creditors should incorporate ESG factors into their credit rating assessments.
   
3. ESG integration is the consideration of financially material ESG issues in the course of investment analysis and decision-making, with a view to gaining a more comprehensive understanding of risk and long-term opportunity.
4. The relevance of ESG issues to credit quality is now acknowledged by the major credit rating agencies. This can be seen with Moody’s and S&P Global both expanding their ESG capabilities to better integrate ESG factors in their credit rating methodologies.
   
5. Besides integrating ESG factors into the credit assessment process creditors are starting to engage more with their issuers to encourage companies they invest in to improve performance and move towards best practice in managing those issues.
   
6. Compared to equity investments, where engagement is considered an established responsible investment strategy, bondholder engagement is a relatively new concept that has only recently gained widespread acceptance. A major hurdle for early adoption was the question of whether investor stewardship should span beyond equities to also include other asset classes that do not grant the investor formal ownership rights.
7. Engagement in fixed income is become more widely accepted due to the fact that companies require continuous financing, as opposed to companies rarely coming to market to issue additional equity.
   
8. The impressive growth of green, social and sustainability bond issuances has further improved investor access to traditional bond-only issuers and, as a result, they have added ESG to their agenda. Green bonds have emerged as an effective investment tool to finance the transition to a low-carbon economy.
9. The recent development of the sustainability bond market has also opened the door for greenwashing. This is where issuers might use the popularity of sustainable bonds in an attempt to gain better credit terms on their bond issuances or create an unsubstantiated, misleading representation in the market.
10. In support of active ownership and investor stewardship, there has been much development in company reporting with an increasing number of issuers producing sustainability reports and using international reference frameworks.