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    Responsible investment in fixed income

    Responsible investment in fixed income

    05 January 2021 Responsible investment, Fixed income

    Fixed income assets are the foundation of many investors’ portfolios and dominate global financial markets. Investing responsibly in fixed income can be crucial for investors looking to achieve either financial or sustainability objectives.

    Summary


    Responsible investors cannot ignore fixed income assets

    Fixed income assets are a core allocation within many, if not most, investors’ portfolios.

    Individuals value the relative certainty that fixed income can bring compared with equities, especially as they approach retirement.

    Institutional asset owners with substantial liabilities, like pension funds and insurers, value the asset class given the contractually defined returns that fixed income instruments offer. This has become a growing trend for maturing pension schemes: as they approach their endgame, schemes pay out more in pension income than they receive from investment returns and sponsor contributions, making the contractual income from fixed income a key component of their strategy.

    The centrality of fixed income is illustrated by the amount of global issuance, which is many times larger than the equity market (see chart below). The role of these assets in investor portfolios, and their dominance across global markets, mean these assets cannot be ignored as investors seek to invest responsibly in pursuit of their goals.

    Fixed income issuance dwarfs equity issuance1

    Fixed income issuance dwarfs equity issuance


    Assessing debt issuers’ sustainability is vital for investors

    • ESG risks can define whether a debt issuer defaults – making them significant for investors
    • There are many examples of ESG risks having a significant financial impact
    • The relevance of ESG risks when assessing debt is widely acknowledged by investor groups and credit rating agencies

    The core focus for fixed income investors is the risk of an impairment to their coupons or return of principal. Any material risk that could affect whether an issuer fulfils these obligations – including environmental, social and governance (ESG) risks – will be relevant to investors’ analysis. This is a central pillar of a responsible investment approach, and reflects a fixed income investors’ natural focus on the sustainability of an issuer’s operations and its ability to afford financial obligations.

    For example, for investors seeking to achieve a specific outcome, such as pension schemes with defined pension obligations, maximising the certainty of achieving this specific outcome is key. Investing with precision, including analysis of ESG risks to help ensure accurate valuations and effective risk management, is crucial.

    The potential materiality of ESG risks is widely acknowledged. There are many examples of such risks having a material impact on the pricing of a bond, or leading issuers to default.

    The Principles in Responsible Investment organisation (also known as the PRI) has an established Credit Risk and Ratings Initiative to “enhance the transparent and systematic integration of ESG factors in credit risk analysis”2 , and global credit ratings agencies now incorporate ESG analysis within their analysis.3

    Fixed income investors can have further-reaching influence than equity investors over governments and companies

    • Fixed income investors can access markets and sectors that are inaccessible to other investors
    • Regular debt issuance provides opportunities for frequent engagement
    • Collaborative initiatives can have a major impact

    Fixed income investors may seek to engage with debt issuers to better understand the ESG risks they face, how they manage them, and in order to encourage them to improve their practices.

    When it comes to engagement, headlines typically focus on the power of shareholders who have voting powers that enable them to influence, and if necessary replace, company executives. The reality, however, is that fixed income investors’ influence can far outstrip that of equity investors; primarily due to a range of institutions dependent on debt capital markets for financing.

    Debt markets provide finance to a wide range of entities, including sovereigns, supranationals and agencies, as well as many companies, some of which prefer to raise finance using the debt rather than equity markets. This means that fixed income investors can have influence on entities and market sectors that are inaccessible to other investors.

    Opportunities for dialogue are often regular. For many institutions access to finance from the bond market is an ongoing necessity, either to fund new projects or roll over existing debt. This stands in contrast to the equity market, where issuance is comparatively rare.

    While for major debt issuers, a single investor or asset manager can sometimes have little effect, collaborative initiatives – where investors work together to achieve a common goal – can have a meaningful impact.

    Famously, when describing the power and influence of debt markets on the global financial system, Clinton-era Democratic adviser James Carville said: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

    This power means fixed income markets can play a central role for investors seeking to influence governments and corporates, whether that is to achieve their financial or sustainability objectives.

    Fixed income investors can pursue precise sustainability targets

    • Fixed income investors can demand changes to the structure and terms of debt issuance
    • Bonds targeting specific environmental and social outcomes are now widely available
    • Tailored portfolios with specific sustainability objectives are possible using fixed income assets

    When debt is issued, fixed income investors have the opportunity to influence the structure and terms of the issuance. A bond with unattractive terms could lead to financing on less favourable terms for an issuer. In rare cases, an issuer may withdraw an issue if there is not enough demand and sometimes change terms or documentation language to comply with investors’ requirements.

    The regularity of debt issuance, combined with investors’ ability to influence the terms and structure, mean fixed income assets offer the potential for meaningful influence. The specificity that is possible to achieve also means investors can target sustainability outcomes in a way that other asset classes – such as equities – cannot offer.

    In the now mainstream ‘use-of-proceeds’ bond market, issuance can be linked directly to specific projects with a positive environmental and/or social impact (the most common are ‘green bonds’, where bond proceeds are used to support environmental projects). Some bonds also build in targets at the broader institutional level, such that if sustainability targets are met, the issuer benefits from more attractive financing terms; and similarly, if targets are missed, the investor receives compensation for this failure.

    The growth of the so-called ‘impact bond’ market means that debt issuers across a wide range of markets and sectors, including sovereigns and private companies, are being encouraged to pursue explicit sustainability objectives.

    It also means that, through the fixed income markets, investors are able to tailor their portfolios and objectives to reflect both financial and sustainability targets in new, innovative ways – that are impossible using other financial instruments.

    The scope of responsible investment activities in fixed income is set to expand further

    • ESG risks are widely analysed for corporate debt, but less so for sovereign and other types of debt issuance
    • More work is needed to develop ESG and sustainability data and research across fixed income markets

    A responsible approach to fixed income, taking ESG risks and factors into account, can support an investor’s financial and sustainability objectives. This is now widely appreciated by investors, but there is still work to be done to refine what this means in practice.

    Fixed income markets encompass a wide range of issuers and instrument types. While the basic principles of a responsible investment approach will remain consistent across them, the practical implications will be different. For example, most analysis of ESG and sustainability risks has focused on corporate debt, with research into their impact on sovereign debt still in a developmental phase. Much of this is down to the availability of good-quality data which is still more accessible at a corporate level. Similarly, managing the impact of ESG risks on a residential mortgage-backed security will be very different to a commercial real estate loan, for example.

    Overall, investors are at the beginning rather than end of their journey with respect to integrating a responsible investment approach into their fixed income portfolios. However, as investor practices evolve, the focus on ESG risks and sustainability factors could provide investors with further opportunities to build portfolios that can target both financial and sustainability targets with greater precision, creating better outcomes for all stakeholders.


    1Source: SIFMA.

    2https://www.unpri.org/investment-tools/fixed-income/credit-risk-and-ratings

    3For example, credit ratings agencies as Moody’s, Standard & Poor’s and Fitch Ratings offer ESG-specific analysis.

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