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Fixed income investors wake up to the importance of ESG
There is no turning back the march of ESG into the bond universe
Jonathan Rogers 1 May 2018

ESG compliance is increasingly used as an analytical tool for equities by institutional fund managers, and high ESG scores have been demonstrated to correlate with superior performance against market benchmarks.

But the use of ESG in assessing fixed income credit risk has been slower to catch on, as has the active engagement of bond investors with issuers in relation to ESG, both during the primary stage of bond issuance and during the life of a bond.

Recent research by Barclays has discovered that ESG is not necessarily an “equity only” phenomenon and can equally be applied to credit markets without compromising bondholder returns.

Indeed, Barclays has demonstrated that issuers with high governance scores experienced a lower incidence of credit downgrades. Moreover, bond portfolios which maximize ESG scores while controlling for other risk factors have outperformed relevant indices, while ESG-minimized portfolios have underperformed.

The price of a bond is derived by discounting future cashflows utilizing an appropriate discount rate. The increasing adoption of ESG into the mindset of the global asset management industry implies that for issuers with low ESG scores, the implied discount rate should be higher than for issuers with high ESG scores.

The reasons are clear. For example, issuers in the fossil fuel industry that have issued long-dated bonds face high regulatory risk and the possibility of “stranded assets” or assets which might no longer be available to service future bond cashflows. Risk factors are also higher for companies with a track record of debt restructuring and opaque accounting standards.

But capturing these risks via quantitative input has proved challenging. And debt holders have tended to have limited engagement with issuers above and beyond their input into bond pricing and structuring covenants during roadshows.

Risk factors such as corporate malfeasance, potential labour disputes, environmental degradation and impact on climate change tend not to be addressed either at the primary stage of a bond’s genesis or during the life of the bond.

One area where ESG factors can be captured in a more systematic manner in the fixed income universe is credit ratings, and the three major credit rating agencies – Moody’s, S&P and Fitch – have begun to increase their consideration of ESG into credit risk analysis.

In 2017, S&P identified over 700 cases where environmental and climate risk had an impact on an issuer’s rating, while around 100 cases of potential credit downgrade action or an actual downgrade were linked to such risk factors.

The London-based Principles for Responsible Investment (PRI) has worked closely with the ratings agencies with the aim of developing ESG-related methodology in the credit rating process. And the PRI recently produced a white paper which aims to encourage more active engagement among fixed income investors and issuers.

Key takeaways from the paper are that bondholders need to engage with issuers despite their more secure position within the capital structure versus equity holders, and that they have the right to engage with issuers in terms of negotiating bond covenants in relation to ESG during the life of the bond, as well as crucially exercising these rights during bond refinancings.

And in relation to ESG, bondholders can achieve a quorum to convene a bondholder meeting should they believe that an issuer has slipped in terms of its stated ESG compliance.

It appears there is no turning back the march of ESG into the bond universe and that those fixed income investors who choose to ignore ESG do so at their peril.

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