27 June 2018

ESG factors increasingly relevant for fixed income investors

Environmental, social and governance (ESG) factors are clearly relevant and material for fixed income investors, according to panellists at Environmental Finance's Fixed Income & ESG conference in London. However, there are distinct differences in the way that ESG factors are integrated into fixed income, compared with equities.

In her keynote, My-Linh Ngo, head of ESG investment risk at BlueBay Asset Management, a specialist active manager in fixed income with over $60 billion in assets under management, said: "You can talk about alpha generation in fixed income, because in the market we generally think some ESG risks are mispriced or not priced at all. So there lies the opportunity."

Ngo found that whereas equity investors had "one investment risk profile" and could take more of a "fundamental view about an issuer" and its ESG risks, fixed income investors however had "multiple credit risk profiles for a singular issuer" depending on the features of notes issued, making ESG analysis more demanding in fixed income.

This, she said, led to bond features playing a key role, such as the technical component and pricing.

She also argued that ESG risks are more "muted" in fixed income and have "more of a delay, potentially", as the asset class looks predominantly at the creditworthiness of companies and default risks.

"Ultimately, credit ratings are very much grounded on the creditworthiness of that issuer – are they going to default? What is their financial strength? So, in that context when you are looking at risks, whether they are ESG or not, they have to be of such a magnitude to move the financial dial on that company," she explained.

In another panel on defining and understanding ESG in fixed income, Julia Haake, head of responsible investment advisory at ISS-oekom, said they had found proof that ESG is financially material to fixed income.

"It's hard to pin it down to certain indicators", she explained, but the company's general view was that "the ESG overall performance of an issuer, be it corporate or sovereign, is meaningful and material for investors".

Haake also elaborated on ISS-oekom's own approach to green bonds, which she described as "dark green". To avoid the risk of "green washing", the data provider analyses the issuer of a green bond, its alignment with the Green Bond Principles, and the use of proceeds in its rating methodology. While others were of the opinion that green bonds can be labelled green when the proceeds are used for green projects, Haake explained that ISS-oekom's definition also includes looking at the ESG credentials of the issuer.

She said: "Of course, they [controversial companies and companies causing climate change] are allowed to issue what they want. But they shouldn't be invested in when they issue a green bond. We are really strict about that."

In the panel on ESG in credit risk and ratings, Carmen Nuzzo, senior consultant in the credit ratings initiative at the Principles for Responsible Investment (PRI), told the audience about the challenges of ESG integration in credit risk analysis.

As the most controversial point, she named the "visibility of ESG risks", which refers to the time horizon over which ESG factors impact credit risk. She said credit rating agencies tend to focus, on average, on a three to five-year time horizon for corporate bonds, but "Investors demand a longer-term view. They want more signals about long-term risks from credit rating agencies".

Michael Wilkins, managing director and head of sustainable finance, corporate and infrastructure ratings, at S&P Global Ratings commented that in order to incorporate longer term, future risks into corporate ratings, the "visibility" of ESG risks needs to become more clear.

He said: "It would be at least unwise, if not imprudent, to actually try and attempt to alter a credit rating to something you are not too sure about, because the visibility is unclear."

However, he believes that the visibility of ESG risks will increase in the future, because of "all these disclosure initiatives like the TCFD [Task Force on Climate-related Financial Disclosures] and other sorts of strong drivers towards better disclosure among corporate issuers".

The current process and situation is "very dynamic", he said, pointing to the growing importance of incorporating ESG risks in the future: "I believe our vision, in terms of incorporating long-term risks into credit ratings, will improve over time".

Other articles so far published on Environmental Finance's ESG and fixed income stream are:

A separate write-up of the stream in the main hall, which focused for much of the day on green bonds, will be published this week.