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Industry Voices

Commentary: ESG factors for the fixed-income investor

Acolytes of Benjamin Graham, Peter Lynch, John Moody and Henry Varnum Poors have long ignored or struggled with the thought of incorporating moral values and social costs into the valuation of a company's cash flows. In recent years, the investment industry has developed a consensus that incorporating environmental, sustainability and governance risks into investment valuation is generally consistent with fiduciary responsibilities. This approach has come to be called by the general term, ESG integration.

ESG integration, as commonly practiced, does not include the practice of excluding companies based on attributes that are not considered to be material investment risks. One of the primary factors in the success of a company is having a comprehensive and accurate view of the risks facing that company. Companies that devote a great deal of resources to enterprise risk management should be better positioned to face challenges than more poorly prepared competitors. In the same sense, investors who comprehensively understand the risks facing an issuer are better positioned to make proper relative valuation comparisons. The old phrase, "what gets measured, gets managed," gives a window into why this is true. Companies and investors who are poorly prepared for unanticipated challenges that arise can be expected to react poorly.

Investors who ignore important information about issuers run the same risk as chemistry students who only read the even-numbered chapters of a textbook. Developing a complete picture of the risks and opportunities facing an issuer must include an examination of ESG factors. Investment analysts who rely on the news feeds that appear on Bloomberg terminals might very well miss a series of small adverse events that make it obvious that a company is poorly managed. As an obvious example, comparing the labor safety records of two mining peers can give important insights into how well the companies are managed.

In fixed income, it is important to remember that credit ratings attempt to measure an issuer's creditworthiness. Part of creditworthiness is an ability to withstand adverse circumstances. Generally speaking, higher rated companies should be able to better withstand adverse ESG events than lower rated companies. At one point, BP PLC estimated the cost of the Macondo oil spill was $62 billion. These costs could easily have driven a smaller, lower rated peer into bankruptcy, leaving bondholders unpaid and in court hoping to get their money back. Because of BP's financial strength and size, shareholders bore the full cost of this disaster.

Social costs

Societies have long struggled with conflicts between economic activities and the associated noises, smells and pollution. As the economic study of social costs and their impact evolved, the regulation of these costs has become more likely. Social costs were the justification for early regulation of air and water pollution and have become the justification for today's soda taxes.

The examination of the long-term implications of social costs raise a time horizon difference between fixed-income investors and equity investors. The long-term implications of social costs are far more important for Coca-Cola Co. equity investors than for an investor looking at a three-year bond. Also, those long-term implications are far more important for an investor in a 30-year Coca-Cola bond than for the three-year bond.

Early socially responsible investors often avoided certain companies solely because of the social costs that companies were imposing on society, without the expectation that society would address the social costs. One can now argue that looking at social costs as an investor is merely looking at long-term risks. There are certainly industries in which one can reasonably argue that increased regulation of social costs will impose costs on the firm, therefore making securities unexpectedly risky. Past investors in coal companies can certainly appreciate this.

ESG for sovereign, municipal and asset-backed securities

The fixed-income universe also includes a wide variety of securities other than bonds issued by the for-profit corporations covered by the ESG rating agencies. There are bonds issued by non-profit corporations, such as universities. Sovereign bonds, asset-backed bonds and municipal bonds each have their own ESG considerations. For example, an investor looking at a 30-year sovereign bond from a low-lying island nation would be remiss to ignore the risks of climate change. The same investor might want to consider governance risk by looking at Transparency International's Public Sector Corruption Perceptions Index.

Industry allocation within a sovereign nation that is perceived to be corrupt can be used to lessen that risk. Companies that have revenues primarily from government contracts can be avoided, with a preference for companies that primarily cater to retail customers. An investor might also express a preference for companies with many customers compared to those with only a few, and for companies with revenue spread across several countries compared to those with revenue from one nation.

Most careful investors also consider governance risks when considering municipal and asset-backed bonds. Experienced municipal investors know that governance risk and credit risk go hand in hand. Late financial filings and a willingness to kick fiscal issues down the road are standard governance issues that are examined by muni bond analysts, as are labor issues that are considered part of sustainability risk.

ESG risks can also be material in asset-backed securities. Governance risk in asset-backed securities was a key trigger of the global financial crisis. The inability of the sponsor to manage sloppy and fraudulent underwriting led to losses for many investors. Investors in securities backed by commercial real estate loans might use LEED Gold and Platinum status of buildings as proxies for evidence of the marketability of the underlying building.

We all know that many corporations benefit society and many impose costs on society. The increased identification of these social costs has increased investor interest in ESG integration. It also has increased the likelihood that bad corporate actors will be penalized by financial markets. Integrating ESG factors into the fixed-income management process is prudent and necessary. And importantly, as other investors pursue ESG integration, it has become increasingly urgent to incorporate this information into the investment process.

Patrick Faul is director of research for LM Capital Group LLC, San Diego. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.