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ESG engagement can open the door to better long-term returns from your fixed income portfolio

By Robert Prospero, CFA, Portfolio Manager, Aviva Investors

It has become widely accepted that incorporating environmental, social and governance (ESG) considerations into an investment process can have a positive impact on long-term portfolio performance. The theory is that by engaging actively with companies and encouraging best practice in terms of factors such as employee welfare, environmental responsibility and the promotion of shareholder interests, large investors such as asset managers can drive change and create value. But while the benefits of ESG are well understood in the context of equities, can the same be said about fixed income?

Invaluable in risk control

The essential way in which ESG can aid fixed income performance is through more efficient risk control. Why this may appear something of a marginal benefit, it must be remembered that the risks of holding corporate bonds are asymmetric. In equities, while it is possible for your investment value to fall to zero, you are compensated by almost limitless upside potential. In corporate bonds, you can also lose all your investment but your scope for compensation is limited. Therefore, generating superior returns in fixed income is as much about avoiding the future defaulters as it is about picking the winners. In this regard, ESG is an extremely useful tool.

While a default may be the worst case scenario, ESG engagement can help identify the type of cashflow, reputation and regulatory oversight risks that can lead to the most widely recognized source of value destruction in corporate bonds: credit rating downgrades. If investors are able to spot such issues promptly they can sell early and be ahead of the game. By the application of ESG analysis that is more thorough than your peers, it is possible to gain a competitive advantage.

Need for better disclosure

Bond investors can also create value by encouraging issuers to improve their ESG disclosure. This can help them understand better how ESG risks can affect not only the company's future earnings, but also more bond-relevant factors such as credit worthiness. It can often be the case that, while companies assume they have a good understanding of ESG risks, they don't see them from the perspective of their bondholders.

Timing can also be a significant contributor to the success of ESG engagement. The key is for bondholders to set out their requirements at the pre-issuance stage, thereby giving themselves more leverage when it comes to contractually obliging issuers to provide information on ESG factors. Furthermore, their influence is likely to be greater in a private placement, where they are able to engage in direct dialogue, than in public issuance.

Obstacles to overcome

So what are the challenges of integrating ESG into fixed income? For the many asset managers who are invested in hundreds, or even thousands, of different issuers, the most daunting problem is coverage. To be effective, ESG requires considerable research resources, meaning that the cost in time and effort could outweigh the benefits if the net is cast too widely. One admittedly less satisfactory approach is to be reactive and only engage with an issuer after a negative ESG event in a bid to repair the damage as quickly as possible. A case of closing the door after the horse has bolted if ever there was one. A more effective alternative could be to shift focus those areas that pose the biggest risk to the portfolio. This could mean concentrating on the largest, lowest-quality or longest-dated holdings. It could also mean focusing more on a sector-by-sector basis.

ESG and sovereign bonds

So far, we have only discussed ESG in the context of corporate bonds. We have made no consideration of the fact that many investors' portfolios are dominated by sovereign bonds. This begs the questions as to how you can use your clout as large investor to influence the errant behaviour of an entire country. The challenge becomes greater still when you consider the counterintuitive fact that deteriorating ESG credentials can sometimes be a trigger for outperformance by sovereign bonds.

As it stands, the best chance investors have of generating positive engagement outcomes in the sovereign bond realm it to concentrate on those areas where their influence is greater, such as in emerging markets. Indeed, the so-called 'bond vigilantes' have already had some success in reigning in the fiscal profligacy of some countries. But whether China will be able to use its vast ownership of US treasury bonds to gain some policy leverage over its number one rival is another matter entirely.

The integration of ESG considerations into portfolios is becoming part of the landscape in fixed income investing. Indeed, it has virtually become a requirement. Plenty of work nevertheless remains to be done, not least in regard to getting ESG reflected in credit ratings. However, with more and more asset managers automatically integrating ESG factors across their fixed income capabilities and the voices of bondholders becoming ever louder, ESG factors can be expected to be an increasingly important catalyst, not only for investment performance but for improvements in our society and environment as a whole.

Important Information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited ( Aviva Investors) as of September 30, 2018. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors' affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

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This sponsored content was not written by the editors of the newspaper, Pensions & Investments, and does not represent the views of the publication, or its parent company, Crain Communications.