Anyone Lost in Fixed Income?

    Guiding portfolio managers and financial analysts in how to incorporate ESG factors into their investment analyses and processes, the CFA Institute and UN-supported Principles for Responsible Investment (PRI) published a report on best practices. The report is based on a survey of 1,100 predominantly CFA finance professionals from around the world and the PRI reporting framework data, which is the largest global database on investors’ ESG practices. ESG integration is defined as “the explicit and systematic inclusion of ESG factors in investment analysis and investment decisions.”

    The report, Guidance and Case Studies for ESG Integration: Equities and Fixed Income1, explains the ESG integration methods of leading practitioners across the world, and provides case studies in how ESG analysis can be integrated into investment decision making. In addition, the report introduces a useful ESG Integration Framework as a reference for comparison of ESG integration techniques at the: 1) Research, 2) Security valuation, and 3) the Portfolio levels.

    Unsurprisingly there is no single best practice for ESG integration; it all depends on the individual firm, its resources and clients. ESG integration complements the practitioners’ existing investment processes and practices, and no major changes may be needed. It combines fundamental analysis of both traditional financial and material ESG information in the security selection and portfolio construction processes. It does not reduce the investment universe by excluding a list of investments. Portfolio returns are not sacrificed, but ESG integration can be used to lower risk and/or enhance returns.

    Fixed income is a later developer into adopting ESG integration compared to equities, but it’s now expanding rapidly with its own integration techniques. Corporate credit analysis often uses the same ESG factors as equity analysis, e.g. corporate governance, or health & safety issues so important for mining companies. ESG factors can be used in credit analysis to help assess the ability of the issuer to pay its debt obligations and liabilities. Through fundamental credit analysis the key credit ratios can then be adjusted for ESG issues.
    ESG integration is used to a lesser degree in sovereign debt analysis where macro-economic factors (interest rates, inflation) are more predominant. It’s difficult to source ESG data on countries, especially environmental data. In addition, the environmental impact is seen as very long-term whereas social factors are more aligned with the investment horizon, and therefore analysed more. Here the perceived national level of corruption can be included to assess a country’s willingness and ability to pay back its debt. Sovereign debt investors can use ESG factors at the portfolio construction level through country and regional allocation.

    ESG integration in Municipal Credit Analysis includes assessing issuers’ governance and management practices. Here practitioners can use credit rating agency research. In Structured Credit Analysis where Asset Backed Securities are collateralized by complex pools of underlying assets, ESG integration would involve analysing risk at several levels: transaction, servicer, collateral, and deal structure.

    Drilling down on a regional basis, the follow-up report ESG Integration in the Americas: Markets, Practices and Data2 indicates that only 13% of respondents in the U.S. state that material ESG issues are always/often included in credit analysis. An article by PRI3 on the report observed that the U.S. is behind the rest of the world in adopting ESG integration. The reason is gaps in empirical research showing links between ESG and financial performance. Confidence in the value proposition of ESG is weaker in fixed income than equities analysis, which explains the lower adoption rate. In addition, lower demand from clients and materiality issues prevent consideration of ESG issues. Some also seem to confuse ESG integration with SRI and impact investing, with fears of excluding investment opportunities through exclusionary screening. The PRI concludes that more empirical research is needed to help U.S. investors integrate ESG and capitalize on opportunities uncovered by ESG analysis.

    PRI admits that empirical studies on ESG benefits in fixed income are challenging because of the difficulty in comparing bonds with different characteristics such as: maturity dates, optionality features, interest rate duration risk, subordination levels, etc. They mention a study by Calvert Research and Management4 from July 2015 where Reuters scores were used to back test ESG factors over the period 2003-13. The simulation used CDS spreads as a proxy for corporate bond returns (bullet maturity structure and isolation of credit risk). The results showed that the companies in the top half with higher aggregate ESG scores outperformed on a leverage and sector neutral basis, measured as the annual rate of change in CDS spreads over the 10-year period. Interestingly, the same back test now using individual E, S and G factors showed outperformance only for the companies with superior Environmental and Social scores. This indicates that Governance issues are already discounted in securities’ prices, but analysis of the remaining Environmental and Social sustainability pillars offer greater alpha opportunities for investors. Perhaps most intriguingly, inclusion of ESG factors demonstrated varying degrees of efficacy across the credit quality spectrum. Lowly leveraged, high quality issuers showed no alpha generating advantage from high aggregate ESG factor scores. Instead simulation indicated that including ESG factors in consideration for highly leveraged, lower quality issuers resulted in outperformance.

    The CFA Institute and PRI reports explain how ESG analysis can be integrated into investment decision making in ways which complement existing analyses and processes. In addition, a useful ESG Integration Framework is introduced as a reference for comparison of ESG integration techniques. ESG integration has a value proposition in that it can be used to lower risk and/or enhance returns. Portfolio returns are not sacrificed, since ESG integration does not reduce the investment universe by excluding a list of investments.
    CFA Society Sweden5 is one of 151 national member societies that support the global mission of the CFA Institute at a local level. Through the annual CFA Sweden ESG Awards, CFA Society Sweden recognizes the individuals, organizations or groups that have raised awareness of ESG considerations in the Swedish financial community. Last year’s Award was presented to the Corporate Human Rights Benchmark (CHRB) which aims to measure the human rights performance of the world’s 500 largest listed companies.

    This article is part of our Handbook “NordSIP Insights – Sustainable Fixed Income”

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    Magnus Kovacec, CFA
    Magnus Kovacec, CFA
    Magnus Kovacec is passionate about investing and writing, but chooses to as much as possible be dispassionate about investments. He has extensive international experience from working with both direct equity investments and fund selection in Developed as well as Emerging Markets. After studying and working abroad for many years, he decided to return to his native Sweden and the city where he was born. Mr Kovacec holds a BSc. from the London School of Economics and a MSc. from University College London, and he is a CFA charterholder.

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