Friday, June 21, 2019

BY STEFFEN REICHOLD, Stone Harbor Investment Partners

Sustainable investment assets globally reached $30.7 trillion at the start of 2018, an increase of nearly 35% in two years, according to the Global Sustainable Investment Alliance. And while the majority of these assets are invested in equity strategies, bond investors are actively participating in the growth of environmental, social and corporate governance, or ESG, investing through various approaches, including purchasing green, social and/or sustainable bonds, launching ESG funds, benchmarking against ESG indices, and embedding ESG factors into the overall investment framework. 

In our view, integration of ESG factors into the fixed income investment process is complementary with fundamental credit analysis and engagement activities with sovereign and corporate issuers. Importantly, active investor involvement can drive change and positively affect sovereign and corporate issuers by creating incentives for them to improve ESG performance and by supporting economic development through fixed income investments.

Of the primary ESG factors, governance is particularly important to bondholders due to the impact it can have on improving institutions and on the rule of law that supports economic development. From a bondholder’s view, the sovereign’s commitment to political stability and security, and the strength of the institutional framework that supports the financial sector are strong indicators for improving creditworthiness. Considerations that are particularly relevant with corporate issuers include management incentives to ensure that their actions do not disadvantage bondholders in favor of stockholders, the structure of the board of directors, and the nature of the shareholding structure, among other factors.

Social issues and environmental factors, while still relevant and important, are somewhat more narrowly applicable compared to the governance factor. For a bondholder, the ability to influence social issues (e.g., worker rights, fair pay and adequate living standards, etc.) is limited. However, where these social issues are inequitable, concerns about the stability of the country are raised, along with questions about the sovereign’s ability to service its debt. Environmental factors are crucial for sectors such as the extractive industries. Again, from a credit perspective, the ability to effectively manage environmental risks (e.g., lapses and accidents) is a key concern as the company’s approach could have significant economic implications for the company, thereby affecting its debt servicing capabilities, as well as causing potential fatalities.

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Improvements in ESG scores, particularly as they apply to governance, are often connected to better returns as the market prices in the improved fundamental (and thus lower risk premium). Therefore, the incentives for both issuers and investors to take actions to positively impact ESG scores are clear: improved ESG factors tend to be associated with lower spreads and thus better returns, benefitting bondholders; and countries and corporations that experience improving ESG scores also tend to undergo economic development and reduce their borrowing costs.

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The increasing demand for fixed income ESG products have also led to the development of tools for investors. Morningstar introduced their Sustainability Rating, which measures how well the holdings in a portfolio are performing on ESG factors relative to a portfolio’s peer group. Fixed income ESG indices have also been developed to provide a comprehensive and efficient coverage of the investable universe. For the JP Morgan ESG index suite, weights are set by scalar as determined by ESG score. For fixed income asset managers, tools that aid in analysis of ESG factors and provide better transparency are critical in managing ESG strategies.

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The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Stone Harbor Investment Partners nor TEXPERS, and are subject to revision over time.

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