This article is a part of NordSIP Insights – Handbook – “Sustainable Fixed Income – 2019”.
At a recent workshop on Sustainable Fixed Income held by NordSIP in Copenhagen, participants discussed the differences between approaches and regulatory support on both sides of the Atlantic, how to use of ESG data and the integration of ESG factors by standard credit rating agencies. Another issue debated at length was the power of ESG factors and their resilience to economic and financial volatility.
There is some work left to be done in sustainable fixed income, but the recent launch of SDG-linked bonds was an important step according to Fabien Collado, fixed income portfolio manager at AXA IM.
“The recent ENEL SDG-linked bond introduced the concept of linking financial returns with impact objective. We need these bonds, where the pay-out depends on whether the issuer can meet its impact goals,” Fabien Collado, Portfolio Manager at AXA Investment Managers, explains. “That SDG bond was the first of its kind, and we expect it to start a trend, where investors look beyond the ‘green’ and do their homework, consider the SDGs carefully and decide for themselves whether the investment is right.”
“However, this type of instrument still needs some fine-tuning to align everyone’s incentives in the right way. At the moment, the bond provides a coupon step up if the issuer does not meet impact objectives.” According to the portfolio manager, there is a danger that such a structure may create an incentive for investors to want to see the issuer fail. “It may be preferable to provide an investment that does the opposite so that the issuer is successful investors part-take in that success through returns.
EU Taxonomy and SASB
The issue of labels brought the discussion around to the topic of instrument classification, taxonomies and regulations. Inevitably the conversation turned to the incipient EU Taxonomy as well as to the work being carried out by the US-based Sustainability Accounting Standards Board (SASB). “The EU Taxonomy is foundational to many of the EU’s other initiatives within the Sustainable Finance package,” Guido Moret, Head of Sustainability Integration Credits at Robeco, noted. “It’s going to have an impact, on its own as well as indirectly through the green bond standard, which will most likely be based on the taxonomy.
“It’s something that will have an impact on the industry,” Moret adds. “The taxonomy itself is mainly a library of economic activities, and whether and when they can be considered to be environmentally sustainable. But, in our case, on the credit side, I think this will first influence the green bonds market once the green bond standard, based on the taxonomy, is adopted.”
Across the Atlantic, investors are not entirely convinced by SASB’s reporting capabilities, even if it is recognised as a useful tool. “SASB tries to help businesses manage and report on sustainability topics” says Brad Camden, Director of Fixed Income Strategy for Northern Trust Asset Management. “However, what we are finding is that not all of the SASB metrics are providing adequate coverage on disclosure topics, and the platform is not robust enough for us to integrate.”
“We quite like the SASB framework as a tool to contextualise what is materially important for each industry,” adds James Tomlins, Fund Manager at M&G Investments. “However, we decided to source our own data internally or filter external data through our analyst team. We use SASB as an initial step to challenge credit and investment analysts with regards to how we ought to be looking at these credits, from an ESG perspective.”
“When we did our analysis, we added a few components, but, it’s a very much similar approach taken by SASB,” Collado agrees. “I like it because they have different metrics for different industries, which are relevant to that industry.”
“Moving to one terminology, or a taxonomy-enhanced framework will help everyone get on the same page. I think it’s a necessary first step,” Tomlins adds.
ESG Data & Rating Providers
To Tomlins, there’s a parallel between today’s ESG data providers and credit rating agencies (CRAs) of the past. “ESG methodologies today are like CRAs 15-20 years ago,” he argues.
“Everyone claims to have an edge in their credit analysis. But everyone uses S&P and Moody’s because clients need a comparable framework to assess risk across firms, and, across portfolios,” Tomlins continues. “I think we’re in a similar space, with MSCI and Sustainalytics. No one thinks they’ve got the right answer, but they provide a good benchmark of comparable metrics, across portfolios, and, across businesses.”
“I completely agree,” Camden says. “It’s more about setting a baseline. The question is how to use the data to meet sustainable investing objectives and to offer solutions. We all know that the CRAs have some flaws. The same applies to MSCI and Sustainalytics in terms of ESG. What matters is how one corrects for those flaws and incorporates the data into a solution.”
Are CRAs Integrating ESG?
Collado is critical of CRAs’ attitude to ESG risks. “They say that ESG has always been an important framework for them and that they have always done it. They don’t acknowledge the fact that the credit firmware they have in place missed part of the risk, which I think is quite poor,” the French portfolio manager says. “There’s nothing wrong with admitting that ESG issues matter more now than they did five or ten years ago.”
“Surveys show that nowadays, 75% of CEOs believe that ESG is important, but the figure was just over 20% ten years ago,” Collado notes. “The market is more sensitive to it, and CRAs are more sensitive to it too. They should just acknowledge that. Instead, they insist that ESG is already incorporated into their credit rating framework and that if it’s material, it’s reflected into the credit rating. However, it’s impossible to reconcile that view with downgrading a tobacco company by six notches on the back of an ADA regulation change.”
Camden tries to see it from CRAs perspective. “They don’t want to change their ratings methodology overnight. It has to be a slow evolution.” However, he argues that some CRAs are more open to change than others. “Fitch seems to be most open, and then, probably Moody’s, and, S&P last. There’s a business incentive. Fitch is probably the least prominent of the three, so it is looking at ways to differentiate itself. Moody’s has been slower, but we have seen changes over the last 18 to 24 months. As Fabien said, they insist that they have always incorporated it, but they are trying to take into account that the financial sector wants a lot more transparency.”
“One contribution that CRAs have made is to help us push for more disclosures,” Collado adds. “We all want more data as do they so when they take up ESG and ask for more data, we all benefit.”
ESG and Market Instability
The impact of ESG factors may also vary depending on overall market conditions. “ESG is a useful risk indicator on the downside. As fixed income is an asymmetric asset class we’ll always have to acknowledge those risk factors as useful investment indicators,” Tomlins says. “In our experience, the ESG portfolio experiences fewer drawdowns than its non-ESG counterpart. It’s easy to ignore it in a low default environment, where that factor doesn’t have a huge impact on returns. However, if we go into a risk-off situation and default rates increase materially to 5%-8%, then I do believe that the ESG risk factor will have a much bigger impact on portfolio performance and returns.”
Another appeal of ESG factors is their long-term relevance. “ESG is here to stay regardless of the economic environment. Climate change and other ESG considerations about society and governance are always going to be pertinent even if the economic environment changes,” Robeco’s Moret argues. “It’s an important source of additional information that is not only useful to clients that are looking to avoid negative impacts. As James said, if default rates go up and markets are more volatile, then additional information will become more valuable.”
Camden agrees. “We’re all investors, investing with imperfect information. Increased transparency offers more data to be analysed , which may lead to new innovative solutions and improved cost efficiency down the road. The desire for low-cost transparent solution has had a significant impact on the fast growth of passive investments.”
The Bifurcated US Market
Arguing about the relevance of ESG at different points in the credit cycle, Camden points out that a shift in market sentiment might just be what is needed to get the reluctant American investor on board. “I think we need some market turmoil to show what ESG can provide during a period of instability. When market volatility is low, particularly in a low-rate fixed income environment with tight credits spreads, the incorporation of ESG into the investment process is not as visible. We don’t really see what value ESG analysis adds. We need market dislocation to promote change.”
“The U.S is bifurcated,” says Camden the American fixed-income portfolio manager. “It’s often all or none,” he adds. “Investors and asset owners are having a hard time taking that first step because they are finding that the solutions are not pure enough. We see a lot of demand for impact investing from the global family office space because of their desire to make a difference, but there are fewer suitable fixed income solutions for them. They feel that public markets don’t make enough of a difference, so they go to private markets. On the other hand, some institutional investors still believe that ESG is going to sacrifice returns, so we need to educate them and dispel that myth.”
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