by Carmen Nuzzo, PRI
Fixed income is catching up with equities
The consideration of environmental, social and governance (ESG) factors in fixed income (FI) markets is gathering pace. Once the exclusive focus of equity investors, the ESG lens is beginning to feature in bond evaluation, starting with credit risk analysis.
Several obstacles have delayed ESG consideration across this asset class until recently. One is linked to its complexity. There are multiple issuers in equity markets, most of which only have one type of share. In contrast, in FI markets, there are fewer issuers – including sovereigns – but a multitude of issues with different maturity, duration and structures.
Another obstacle stems from the lack of engagement culture. Unlike equities, the absence of voting rights in FI markets is often viewed as a reason to evade dialogue with issuers. This is particularly the case with sovereign issuers.
Additionally, research in this field is limited, as academic and market research tends to focus on the impact of ESG factors on equity performance. With little evidence of a clear link between ESG factors and FI valuations, bond investors have shunned the ESG business case.
However, things are changing rapidly. Appreciation of ESG consideration as a tool to better manage downside risks is growing; client demand is on the rise; and the frequency of environmental incidents are making climate change no longer a distant, intangible threat. Finally, regulatory pressures have also been building up, notably in Europe.
It is also becoming increasingly clear that better and more systematic ESG integration in credit risk is crucial for investors that buy bonds for capital preservation – particularly insurers and pension funds which own considerable amounts of long-term FI securities for asset-liability management.
Admittedly, many ESG factors have traditionally featured in credit risk analysis; but they have not been labelled as such. They may have been considered as part of the industry or business risk of a corporate issuer, or part of geopolitical risks in the case of a sovereign issuer. Other risks that were once perceived as long term are also now moving sharply into focus. Others are nascent or viewed as potential at this stage.
Perhaps most importantly, the practice of credit risk analysis is evolving. Market participants are more mindful that the lack of proper oversight, transparency and accountability of an issuer (including sovereigns) can negatively affect FI market pricing, volatility and, ultimately, financial stability. Furthermore, they are beginning to price risks differently, including those linked to non-financial variables such as pollution, once treated as negative externalities.
For example, when assessing a polluting company, investors may now not only focus on how much CO2 the company emits but also on the material impact – including financial, regulatory and legal factors – of those CO2 emissions.
ESG in Credit Ratings Initiative
The Principles for Responsible Investment (PRI) was among the first organisations to recognise the importance of engaging with credit rating agencies (CRAs) as well as investors to advance understanding of the impact of ESG factors on credit risk assessment, improve risk-adjusted capital allocation and promote sustainable investing. In May 2016, it launched the ESG in Credit Ratings Initiative, currently supported by 138 institutional investors globally (with over $27 trillion of assets under management) and 18 CRAs. The latter include large players such as Fitch Group, Moody’s Investors Service and S&P Global Ratings, as well smaller regional players, with specialty products or a more explicit ESG reference in their methodologies.
Through the initiative, investors and CRAs have been engaging during 15 roundtables organised by the PRI across the globe on topics such as the materiality of ESG factors that can affect the relative probability an issuer default; the credit-relevant time horizons to consider; and whether ESG consideration should take an “add-on” approach – keeping ESG analysis separate but complementing traditional credit risk analysis – or a “built-in” approach which is more integrated but inevitably harder to demonstrate. Another important issue raised is the challenge of bolstering capacity and resources for credit analysts to have the adequate skills to assess new and emerging risks. This dialogue is documented in two reports of a three-part series: Shifting perceptions, ESG, credit risk and ratings – part 1: the state of play and part 2: exploring the disconnects.
One of the resounding outcomes of the PRI roundtables is that building a more quantitative ESG framework is currently the biggest challenge faced by practitioners on both sides. They cite insufficient comparable data, too much non-material information and a plurality of reporting requirements as a barrier to data standardisation and cause of inconsistencies. Additionally, because some ESG factors are new (such as cybersecurity or the effects of disruptive technologies), time series analysis and back-testing may be redundant. Modelling often-intangible non-financial risks and capturing data interdependency is an added complication.
There is also no silver bullet when it comes to choosing relevant time horizons, as considerations vary based on investment objectives and whether the credit risk of a bond issuer or a single issue is assessed. Time horizons also depend on the visibility of future risks and the probability that they will materialise, the likelihood of them reoccurring and whether they impact a bond issuer’s cash flow and balance sheet, as well as its ability and preparedness to adjust business models in line with changing ESG risks (see Figure 1).
While it is too early to identify clear solutions to the problems encountered by investors and CRAs when incorporating ESG factors in credit risk analysis, ideas are beginning to come to the table. They will form the base of part three of the PRI’s series of reports on the subject, which is in the pipeline.
Meanwhile, capacity is building among some of the trailblazing investors and larger CRAs, with organisational changes and expanding resources, including intellectual capital. On the CRA side, examples of rating changes following more systematic and insightful consideration of ESG factors – particularly environmental ones – are emerging. Indeed, Moody’s Investors Service recently warned that widening inequality will weigh on US crediti. It also downgraded twice this year Pacific Gas & Electric Company on concerns related to governance and for its substantial exposure to the 2017 Northern California wildfiresii.And S&P Global Ratings, through back-testing, has analysed how environmental and social factors have affected past changes in ratings or rating outlooksiii.
Although far from being mainstream, ESG consideration in credit risk analysis has turned the corner – and is here to stay.
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