ESG factors making gains in fixed-income portfolios

The integration of environmental, social and governance factors into fixed-income portfolios is gaining traction with money managers across the globe, as they and their institutional investor clients realize large parts of their portfolios are not up to scratch on sustainability.

Sources at consultants and money management firms said they are seeing increased interest from institutional investors in integrating ESG factors into fixed-income portfolios — something they are surprised has taken so long. Managers already integrating ESG factors into their fixed-income processes said they are also seeing increased inflows.

ESG integration in fixed income has been called the “neglected child of responsible investment, but it is the sleeping giant, as it is a huge asset class and very important,” said Archie Beeching, senior manager, fixed income in the Principles for Responsible Investment's investment practices group, based in London. “Most pension funds and insurance companies have very large fixed-income allocations,” yet ESG integration has been focused on public and private equity, he added.

Given fixed-income investing is about identifying downside risk, and ESG analysis has been shown to be most relevant in this context, My-Linh Ngo, senior ESG analyst at BlueBay Asset Management LLP in London, said: “It is surprising that ESG is more established on the equities side than on debt, especially given it represents a bigger asset class.”

Ms. Ngo thinks it might be as a result of “the equity side having the owner/shareholder dimension, which makes corporate engagement on ESG risks more natural, and also perhaps because share price sensitivities to ESG risks are more direct as they are influenced by sentiment.” When it comes to debt, however, prices and spreads “are buffered to some extent by credit strength, which may not be immediately impacted.”

Mr. Beeching said a number of institutional investors are now realizing they cannot apply ESG factors to just part of their portfolios “but need to do so universally.” They are increasingly engaging with money managers to ensure their processes are robust, and they are also asking more difficult questions, he said.

Executives at a number of pension funds across the U.K., continental Europe and the U.S. could not be reached for comment. However, money management executives said they are seeing increased interest in ESG bond portfolios or the integration of ESG factors into fixed-income strategies.

“We are seeing tremendous interest in ESG bond portfolios,” said Alex Struc, London-based portfolio manager at Pacific Investment Management Co. LLC and co-head of the ESG effort at PIMCO. “There is a lot of short-termism in markets today; however, investors are starting to recognize that considering factors like a business' approach to environmental, social and governance factors is critical in identifying long-term value. Investors that do take a broader, longer-term view have an edge in unlocking that value, especially within fixed-income markets.”

Short-term thinking

Short-term thinking comes up with consultants as a reason not to integrate ESG factors into fixed-income portfolios, said Mathias Neidert, London-based head of public market research at consultant bfinance. “Another argument often brought forward to explain the relative irrelevance of ESG in fixed income is the inherent defined maturity of investments. Those who consider ESG factors for equity investments agree that sound ESG practices, or the lack thereof, have an impact on the long-term value of companies. Some argue that bondholders disregard long-term value as their investment is going to be repaid cum interest over the short to medium term,” Mr. Neidert said.

While there might be a perception of short-termism in fixed-income investment, Lionel Pernias, head of buy and maintain, fixed income, at AXA Investment Managers in London, said the investor base in ESG fixed income is “stickier. They invest for the long term.”

The case for integrating ESG factors into bond portfolios was reinforced in research published by Barclays in October, in which the bank constructed diversified portfolios to track the U.S. investment-grade corporate bond index. These portfolios were given either a positive or negative tilt to different ESG factors. In comparing the excess returns of a high-ESG-factor portfolio with a low-factor one, the high-ESG tilt outperformed steadily, using data from both sustainability research firm Sustainalytics and index provider MSCI Inc. The annual excess return over the past seven years averaged 29 basis points using Sustainalytics data, and 42 basis points using MSCI data.

Barclays concluded that using an ESG tilt in an investment-grade fixed-income portfolio is not detrimental to returns and can, in fact, be beneficial.

While difficulties in application were highlighted by sources as the reason ESG integration has not been popular in fixed-income portfolios to date, there are a number of ways institutional investors can choose to go down the sustainable route.

“We see in the market that fixed-income (ESG integration) is lagging, but in terms of content and rationale, there is no difference,” said Edith Siermann, Rotterdam, Netherlands-based chief investment officer, fixed income, at Robeco. Ms. Siermann said one reason for the lag is that voting on issues is more an equity phenomenon than fixed income.

But Robeco applies ESG integration and engagement in its fixed-income portfolios “just the way we do on the equities side — both credit portfolios and government bond portfolios.” The firm has developed ESG scores for its exposures, based on data and research.

ESG tilting

Sources said integration of ESG factors into bond portfolios works well, as does ESG tilting, which allows investors to more directly express a positive or negative view of the ESG factors in a portfolio.

But popular options — exclusion and engagement — for integrating ESG factors into portfolios in equities might not work for bonds.

Negative screening, when investors identify sectors they wish to avoid, such as tobacco, is a straightforward option for equities but not necessarily so for fixed income, BlueBay's Ms. Ngo said. “For instance, if you want to exclude the extractives sector, but you also want emerging markets debt exposure, then (negative screening) could be problematic as this represents a material part of the issuance market.”

Applying an engagement strategy to a sovereign bond allocation, as opposed to a corporate strategy, also is challenging. Ms. Ngo said all this highlights the need for debt investors to consider ESG investment strategies that take sufficiently into account the technical characteristics of the asset class.

While uptake is in its infancy, there are some leaders.

“Emerging markets debt funds are leaders in this. There are so many more hidden risks, more questionable financial reporting coming from (some emerging markets companies), and not the same regulatory structure around debt issuance,” PRI's Mr. Beeching said. “A governance review is even more important.”

And the emergence and increasing popularity of green bonds is encouraging, although sources said it is only start. “There is so much confusion still (in the) green bonds story, which gets all of the media attention and hype. But it is still only 0.5% or less of the market,” Mr. Beeching said.