Commentary: One size does not fit all – ESG analysis in fixed income

Fixed-income investors have sharpened their focus on environmental, social and governance risks as the pandemic has highlighted the vulnerabilities of different sectors and industries, with default rates expected to rise sharply.

The collapse of Wirecard serves as an example of the need for stronger governance after revelations of over-indebtedness and reported incidences of fraud at the German payments company led to significant losses for many investors.

After many years of integrating analysis of ESG risks into investment decision-making, we believe there are important lessons for fixed-income investors to learn.

Fixed-income investors are particularly attuned to default risk, and so any material risk — including ESG risks — will be relevant to their analysis. Many investors have long sought to take such risks into account, but there has been notable progress recently. The influential Securities and Exchange Commission Investor Advisory Committee has called for rules mandating ESG risk disclosures, citing the need for reliable ESG information on which to base investment and voting decisions.

Separately, the Department of Labor has proposed a rule preventing some employee benefit plans from pursuing "non-financial objectives" if returns or participants are put at risk. While this may present a challenge for investors seeking a positive non-financial impact, we believe it has led many to focus on how they can benefit from ESG analysis in the course of pursuing their financial objectives.

However, while the term "ESG" is now commonplace, there is no broad-brush approach to ESG analysis, or consistent data to feed into a standardized rating or score. Different ESG data providers offer varying assessments, with inconsistencies, gaps and potentially misleading ratings. Investors can benefit from developing their own approach to assessing ESG factors, rather than depending solely on external providers.

We have found that when looking at different forms of fixed income, their different characteristics mean that investors might need to apply different emphases in their ESG research before making an investment decision.

ESG data providers typically cover most investment-grade companies, but may offer very different assessments. Digging deeper through independent analysis and proactive engagement may still be necessary to fully understand the risks they face. One example is Wirecard, where major ESG data providers offered very different assessments of its governance and accounting.

ESG risks can be even more significant for high yield than for investment-grade debt. This is due to the prevalence of sectors — such as energy — which typically have higher short- and long-term risks. Independent data providers generally assign worse ratings to this asset class, or none at all, since many issuers are private. As such, it is worth investors engaging directly to capture the whole picture.

The three largest emerging market corporate defaults in 2019, totaling $5 billion in bond debt, all suffered from significant ESG issues with very poor disclosure and weak governance. This demonstrates why, for every investment made — both corporate and sovereign — investors can benefit from analyzing the ESG risks an issuer faces, as well as its ability to manage those risks.

Relying purely on data providers may mean missing out on potentially viable opportunities, as emerging market issuers are generally covered less. As an example, we identified a Russian transportation issuer with no external ESG rating. Following engagement, the company was able to provide the additional information required for us to retain exposure.

Applying ESG scores to structured credit securities can be complex. There can be many stakeholders in the supply chain, and special purpose vehicles are often not discrete: For example, the mortgages within an SPV can change, and the environmental quality of the houses might change over time.

There is no commonly established approach for identifying or assessing ESG risks within structured credit. We use ESG risk questionnaires for auto loans, credit cards and residential property, and are developing questionnaires for commercial property and collateralized loan obligations, to understand how the market is evolving and to foster a culture of transparency within the asset class.

The relevance of ESG factors for sovereign issuers remains at a developmental phase, though ESG factors can prove significant for emerging market issuers in particular. We have found it beneficial to analyze sovereign ESG risks using multiple inputs including publicly available data on environmental and social issues.

That said, in our experience, there is scope for investors to engage with sovereign issuers on specialist issuance such as green bonds.

Outstanding impact bond issuance surged past the $1 trillion mark in May. We have seen a material shift across our client base, especially in Europe, toward strategies that embed investor values in how they are designed. Where investors are allocating for both financial and values-based returns, it is important to avoid what is known as greenwashing or impact washing, and this brings in a further data challenge.

We have found many issuers labeling their bonds as having a green or social impact with little intention of using the proceeds toward any demonstrable "impactful" purpose. Out of 200 impact bonds we have rated since 2017, only 33% have met all of our requirements to be classified as a genuine impact bond.

This again demonstrates the need for qualitative, proactive engagement and analysis.

Failure to comply with recognized ESG standards can pose a threat to the financial performance of companies across the entire universe of debt investments. Trusting third-party data is not enough. Having a good understanding of the risks in each area, and addressing them in analysis, is crucial for those looking to achieve their financial and non-financial goals.

Alex Veroude is chief investment officer for North America at Insight Investment, based in New York. 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.