ESG factors make inroads in fixed-income portfolios

Bond managers are working to add environmental, social and governance factors to their investment processes to meet growing client demand for responsible fixed-income investments. The trend, at an early stage of development, is furthest advanced among large, sophisticated investors in Europe and North America. Managers that have taken strides to incorporate ESG factors into investment processes include Aviva Investors, AXA Investment Managers and Schroder Investment Management Ltd., while pension and sovereign wealth funds that have pledged to do so include the 2.86 trillion Norwegian kroner ($452 billion) Government Pension Fund-Global, Oslo; the €208 billion ($263 billion) Stichting Pensioenfunds ABP, Heerlen, Netherlands; the $206.7 billion California Public Employees’ Retirement System, Sacramento; the £3.8 billion ($5.9 billion) London Pensions Fund Authority; and the £1.4 billion Environment Agency Active Pension Fund, Bristol, England.
Most ESG integration into mainstream investments has been in equities. That’s because bondholders lack the voting power shareholders have, and generally don’t have the ear of corporate leaders the way shareholders do, experts say.
“You don’t get invited to the (annual general meeting), so that engagement is very difficult to do,” said Mark Gull, partner and head of fixed-income asset management at Pension Corp., London.
Still, bond investments are growing as a share of total assets at most European pension funds and many U.S. ones; as closed and frozen defined benefit funds are wound down, trustees typically increase bond allocations at the expense of stocks. That means responsible bond investing will only become more important in the future.“The trajectory is clear,” said Will Oulton, London-based principal and head of responsible investment for Europe, the Middle East and Africa at Mercer LLC. “The question is, how does that get applied across the whole investment process.”
Most managers see a strong case for including governance in investment decisions. “There’s been enough corporate governance catastrophes that have ended up with companies defaulting” to lead managers to look much more closely at governance processes, said Emma Hunt, senior investment consultant in Towers Watson & Co.‘s sustainable investment team. “They’ve really upped their game.”
Credit-rating agencies have included corporate governance in their bond ratings methodologies for years, and AXA Investment Managers found in a 2009 in-house study that good corporate governance reduces default risk, and leads to better credit ratings and lower debt costs. “The corporate governance of a company is a material issue in understanding the risks and opportunities associated with its ability to preserve and create value for its shareholders — as well as meet its debt obligations to bondholders in a timely manner. And while their strategic focus may differ, the interests of shareholders and bondholders in ensuring the companies they are invested in have sound corporate governance policies and practices are aligned,” according to AXA IM’s study, titled “Can corporate governance take — partial — credit for fixed-income performance?” Hunt compared the effect of ESG factors on bond performance to crocodiles in the water — a lurking danger that nobody sees until it’s too late. “The thing with crocodiles in the water, it’s a bit all or nothing,” said Ms. Hunt, who is based in Reigate, England.

Similarly, Fitch Ratings calls corporate governance an “asymmetric consideration.” That is, the ratings agency puts little weight on corporate governance for bonds issued by companies whose governance is sufficiently strong. “Where a deficiency which may diminish bondholder protection is observed, the consideration may have a negative impact on the rating assigned,” according to a methodology explanation on Fitch’s website.
“On the one hand, there is a financial case” for integrating ESG factors, Ms. Hunt said, adding that the “second element is value alignment.” Institutional investors are concerned with investment returns, but also with social and environmental issues that represent reputational risks for them. Experts say pension funds are increasingly issuing RFPs that require bond managers to disclose how they will incorporate ESG factors into their investments and talking directly to existing managers about ways to invest responsibly. “We’re seeing a lot more demand in terms of RFPs,” said Richard Stathers, equity analyst and head of responsible investment at Schroders in London. He said Schroders is “just scratching the tip of the iceberg at moment” on ways to integrate ESG factors into bond investments. But integration into bond investments is in the early stages. Spokesmen for CalPERS and ABP said pension fund staffs are working through the issue, but they said it will be months, even years, before responsible investment in bonds reaches the level it has in equities. “Assessing ESG issues within fixed income is in its infancy compared to the attention that equities has,” Aled Jones, ESG investment director at the London Pensions Fund Authority, said in an e-mail response to questions. “Our approach is to discuss with our fixed-income managers how they are incorporating an assessment of these issues into their research process.” Also, fund staff meets annually with managers of the fund’s largest mandates to discuss ESG matters.One way bond managers are hoping to meet the growing demand for ESG integration is by looking to third-party experts.
For example, Muzinich & Co. Inc., New York, outsourced ESG integration of its Enhancedyield Short-Term fund to Sustainalytics Inc. The Amsterdam-based firm applies an ESG screen to companies Muzinich provides, with the result being a high-performing strategy that invests in companies with strong ESG ratings, said Tatjana Greil-Castro, managing director and head of Muzinich’s London office.
Supporting companies that are working to improve any ESG-related concerns investors might have “will get companies to move more in the right direction than just turning your back to it and pretending it does not exist,” Ms. Greil-Castro said.
Engagement presents a significant hurdle to responsible bond investments for pension funds because of the lack of a straightforward process such as shareholder voting, but that doesn’t mean it can’t be done, experts said. For example, large bond managers can grab the attention of companies when they’re about to issue new bonds.
“The ability to engage is clearly there” at the time of issuance, said Colin Purdie, sustainable and responsible investments credit fund manager at Aviva Investors, London. Mr. Purdie joined Aviva Investors in July partly to help integrate ESG factors into bond investments.
Aviva Investors coordinates engagement work across asset classes to concentrate the power of the firm, and to expand its access. “We have first-class access as shareholders and bondholders,” Mr. Purdie said. “Companies have an ongoing need to finance themselves. It’s in their interest (to engage with us).”
Drew Carter is a reporter with Pensions & Investments
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