Incorporating environmental, social and governance (ESG) factors into fixed income investment

30 April 2018

This report aims to promote strategies for including environmental, social and governance (ESG) criteria in investment decisions within fixed income. It provides an overview on sustainable investing in fixed income across five core areas building on research, practical experiences and a literature review to inform findings.

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OVERVIEW

This report provides an overview on sustainable investing in fixed income, specifically around the topic of environmental, social and governance (ESG) investing. It discusses this over five core areas focusing primarily on the main fixed income instruments such as sovereign, supranational, and corporate bonds. The study builds on research and practical experiences to date on ESG approaches for fixed income portfolios and includes a literature review to inform findings.

The report starts off by looking at the specific nature and issues of ESG investing in fixed income (FI), where FI investment is very much a quantitative process and managers sometimes find it difficult to include ESG criteria in their financial models. The report looks at key differences in FI compared to equities and the implications of these differences, while then analysing the various types of securities and how ESG can be applied to each. For example, ESG analysis in asset backed securities needs to capture risks relating to the originator of the securities, the servicer and the ‘cover pool’ of assets. Here investors should consider how ESG factors could affect the financial sustainability of these pools.

Exploring the rational for ESG in FI, in particular its impact on financial performance, the report through a literature review highlights key findings in the industry across different bonds and funds. It notes that while there are a wide array of different approaches that use different methodologies, data sets and time frames the overall growing body of research supports two widely held views; that ESG factors can constitute material credit risk and incorporating ESG factors does not mean having to sacrifice return.

ESG investment tools for FI is a third area discussed and it examines a number of ESG frameworks that have been developed for bonds in relation to credit ratings as this is seen as a fundamental element of FI management. These tools include ESG scores and rankings as well as FI indices. In assessing both these tools the report highlights that scoring and indices, whether that be externally or internally provided, seem to differ. This is due to the different preferences of providers that influence methodology and weightings.

The report then dives into how ESG is being implemented by FI investors, specifically looking at the differences in approaches as these vary due to size, regulatory framework, nature of business etc. The report notes while ESG investing is developing fast, this approach to investment means different things to different people thus there is a question on what the real implementation is. The report then looks at implementations of ESG in FI across various strategies.

Furthermore, trends, challenges and the issue of customisation and standardisation of ESG strategies is discussed. Some of these include:

More academic research on FI related ESG issues have been undertaken and continues to grow
Focus on environmental and social outcomes is increasing
There is a lack of clarity around the ESG terminology; vagueness of ‘sustainability
Who defines values and how? Concerns over growing ‘oligopolistic role’ of external agencies and service providers.

The report finishes by noting key lessons that fixed income investors should look at when incorporating ESG into the investment decisions as well as the ways forward to make ESG integration a truly mainstream approach with a material impact.

KEY INSIGHTS

Capital markets play a vital role in channeling investment into the economy to help drive growth and prosperity. Today asset owners and financial intermediaries are being increasingly asked to contribute to financing sustainable development that meets the needs of the present, without compromising the needs of future generations.
Investors are using a range of methods for bringing ESG considerations into their decision making. These methods are not mutually exclusive and are often used in combination. These approaches can be used passively or actively.
The relevance of various ESG approaches seem to vary across asset classes and types of fixed income securities. E.g. there seems to be significant scope for ESG integration across these equity and fixed income securities however when looking at different approaches across sovereign issuers there is limited scope.
Many studies have been published trying to establish an empirical link between ESG and financial performance. In a comprehensive survey which summarised the results of 2,200 primary and review studies, roughly 90% of studies found a non-negative relation between ESG and corporate financial performance (CFP).
ESG investment tools which have been created to assist investors in the space of fixed income include ESG scores, rankings and indices.
There is no standard approach for implementing ESG into the investment process and investors are finding what approaches best suit them. This is dependent on a range of different factors, however in snapshot survey of 109 fixed income managers by Russell Investments this found that 68% of managers have integrated ESG somehow into the investment process.
Green bonds and climate bonds are by far the most popular form of themed investments in the context of ESG. In the green bond market in 2017, over $160 billion was issued, with over U$200 billion in green bonds already issued between 2007 and 2016.
Standardisation and customisation is becoming a topic of discussion as ESG integration is becoming a more widespread practice. Many investors are increasingly looking to develop bespoke strategies to reflect their own philosophy and investment goals.
Many investors have been taking single steps to incorporate ESG investing into their fixed income whether that be through buying an SRI. However, to really progress investors need to be taking a full organisational approach to ESG investing, devoting in-house analytical resources and applying appropriate aspects of ESG strategies in parallel, including incorporation across fixed income holdings.
While ESG investing is developing fast towards a more outcome driven activity, more still needs to be done to truly mainstream this approach and have a material ESG impact. Not only investors but a range of stakeholders have a role to play to achieve this goal. For example the role of governments to provide more timely, accurate national data on ESG and development issues as well as corporations continuing to improve their reporting on ESG.