The importance of ESG in fixed income
Environmental, social and governance (ESG) analysis adds an extra dimension to investing. Its critical approach can help protect portfolio returns.
ESG factors can have a material impact on a company’s financial profile, credit quality and investment returns. ESG analysis has traditionally been focused on equity portfolios, with investors less aware of how ESG integration can be effective in fixed-income investing. But things are beginning to change.
The reason that capital preservation is so important in a fixed-income context is that, while bond investors do not share the same upside as equity investors, they face the same downside risk (of default). Extreme events are low in frequency but high in severity, and it can take a long time to recover, especially in a bond portfolio. We have seen two well-known examples in the oil & gas industry, where significant losses were incurred by bondholders as well as shareholders, owing to oversight in health and safety and anti-bribery and corruption controls respectively.
There is academic evidence to support the case for ESG-minded investment in fixed income. The research has concluded that poor environmental management leads to a higher cost of debt, that good employee relations mean companies are better protected from financial distress, and that robust governance reduces default risk, thereby influencing credit spreads positively.
What practices and structures should you look for in a credible manager to show they are effectively integrating ESG considerations in their decisions?
First, look for a manager who is really doing what they say they are. It is easy enough for an asset manager to claim it is integrating ESG factors, but it is actions that matter. There are various ways of incorporating ESG considerations in fixed-income investing, such as screening out whole sectors, only investing in the best-rated companies, or allocating to green bonds (traditional in structure, but where the proceeds are directed to projects with environmental benefits). Each of the approaches has limitations.
Although it is possible to screen out sectors or run portfolios with specific objectives, we believe the best way is to integrate ESG analysis actively in the investment process, by analysing both sovereign and corporate bonds and evaluating risks and opportunities across the credit-rating spectrum. At Newton, we’ve been doing this for over 30 years and believe this is the most effective approach.
The combination of a ‘top-down’ approach to thinking about headwinds and tailwinds for countries and sectors, and in-depth ‘bottom-up’ evaluation of the strengths and weaknesses of individual companies, can provide a well-rounded view.
We also screen for controversies to see if companies are accused of breaching international norms and conventions, including human rights, labour rights and biodiversity.
Secondly, what is really important is to look for a dedicated responsible investment resource. Where ESG issues are identified, there should be a specific team that has the knowledge and expertise to carry out a thorough analysis of the ESG-related risks. This includes having the skills to engage and try to influence company behaviour for the better.
As an example, amid the big drop in the oil price over the last two years, we reviewed the risk of stranded assets in our energy holdings from a top-down perspective. Fossil fuels will remain part of our lives for a while yet, and energy production delivers valuable social benefits. We conducted fundamental bottom-up analysis to weed out companies either with poor-quality assets which will become economically unviable or that cannot afford to service and repay their debts. In fact, 26% of US high-yield energy debt has defaulted in the past year, so picking the winners has been very important.
We need to appreciate that ESG-related risks can take time to play out, however, and it is important to do your work. As a sovereign bond example, Zambia (reliant on copper for over 80% of its exports) issued a bond in 2012 that was hugely oversubscribed and initially performed well. However, we avoided this as the bond’s pricing appeared to reflect no appreciation of the challenges ahead or the fact that growth plans were based on continued strong copper demand and prices. Subsequently, government spending levels were unsustainable, the copper market cracked, politics has become challenged, and the government is now considering an International Monetary Fund bailout. Zambia’s bonds have been downgraded and are trading well below par. It pays to have a sceptical view and think about the long term.
Governments are responsible for peace, security and development in their countries. Factors we look for in determining sustainable economic development include the availability and quality of human, social and political capital, the level of natural resource depletion, conflict and political change.
The last thing to look for is evidence of what the manager is doing in the form of disclosure of engagement and voting. This forms the basis of transparency and the opportunity to question decisions the manager has made. Bond investors occupy a different place in the capital structure to equity investors, and their challenge is that they don’t get a vote and so they may find it hard to effect change. However, they can still engage with companies to inform decision-making and improve company resilience. We meet management teams frequently, vote on corporate actions, and collaborate with our equity colleagues in relation to companies whose bonds and equities we own. We ensure transparency by disclosing all engagement and voting activities quarterly.
To conclude, we believe that incorporating ESG factors in fixed-income investing through a fully integrated approach helps us to be a better investor. By analysing investment opportunities from all perspectives, we aim to make better decisions and, crucially, preserve capital value.
 Corporate Environmental Management and Credit Risk, Bauer and Hann, 2010
 Employee Relations and the Likelihood of Occurrence of Corporate Financial Distress, Kane, Velury, Ruf, 2005
 The effects of corporate governance on firms’ credit ratings, Ashbaugh-Skaife, Collins and LaFond, Journal of Accounting and Economics, 2006