Fixed income - a good place to start with ESG
Investors commonly consider equities to be the obvious place to begin implementing ESG strategies. However, we believe fixed income is a more natural primary focus.
ESG factors are a source of credit risk. Ignoring them exposes investors to greater risk of downgrades, distress or default.
ESG-related events (such as the Deepwater Horizon spill, auto emissions scandals, poor labor practices and financial fraud) can become public relations disasters and directly wipe out value.
We therefore see ESG as a crucial risk management tool in fixed income and an additional line of defense against permanent losses of capital.
Common ESG risk examples
- Environmental impact in sectors such as metals and mining, utilities, transportation, cruise lines and waste management
- Employment practices in companies with large labor forces
- Data security in financials, healthcare and technology
- Business ethics in pharmaceutricals, healthcare, financials, gaming and construction
- Consumer protection practices in securitizations
- Employee engagement, diveristy and inclusion in technology and financial services firms
We believe strong ESG performers are generally better investments
In our view, companies that perform well on ESG metrics tend to be stronger from a fundamental credit perspective.
Poorly operating companies are often too preoccupied with fixing their core business models to consider ESG-related risks, which can accumulate over time and become fundamental credit risks.
Whether companies pay attention to ESG because it is ‘the right thing to do’, or as insurance against reputational or regulatory risks, the outcome will be to reduce these risks and potentially improve their long-term business prospects.
Financial impact and the information age
We believe traditional financial metrics fail to capture the full picture of a company’s financial situation, business risks and the quality of management.
An increasing share of corporate value is in intangible assets – which includes reputational risk. The rise of social media highlights how corporate incidents can go ‘viral’ and punish companies financially. Furthermore, as the socially-conscious millennial and ‘generation Z’ cohorts emerge to prominence among society – so too are the social and sustainability issues that are important to them.
Furthermore, today, active managers can measure such factors that were once unmeasurable, thanks to ever-improving tools, data and research.
As such, now is perhaps the right time to implement ESG approaches to help protect against related additional downside credit risks. The danger stemming from unchecked ESG risks will potentially only rise over time.
Exclusion vs. engagement
Investors may choose exclusion and/or engagement to reduce ESG risks.
‘Exclusion’ policies, for example blacklisting all companies within certain sectors, may conflict with the objective of maximizing returns. Also, depending on the time horizon of an investment and the extent that companies can source plenty of demand for capital elsewhere, they may also have a limited impact.
‘Engagement’ policies, by contrast, focus on working with issuers to advocate best practices and to reduce ESG risks.
We increasingly find engagement is a better way to produce positive outcomes than exclusion. For example, while an exclusion policy may forbid energy sector investments, an engagement strategy may identify and work with energy companies preparing for a low carbon future – as these credits may have compelling long-term credit metrics.
As such, engagement permits investments within ‘problematic’ industries on a security selection basis where long-term ESG-related risks are being adequately managed and compensated.
We believe investments based on engagement can additionally send a signal, encouraging other issuers to address their longer-term ESG risks. This has the potential to help improve credit metrics across entire sectors.
For example, Insight is supporting engagement with two of the world’s largest multinational companies, one an energy firm and the other a mining giant. We monitor their climate strategies and have seen been a noticeable improvement in communication and leadership. One of them recently issued the market’s first sustainability-linked bond. Both have also made additional commitments regarding their coal-related business practices1.
We believe our engagement will help protect our clients, help issuers lower borrowing costs and generate a positive impact.
Engagement may also suit investors concerned that exclusion policies conflict with the objective of maximizing returns.
ESG and COVID-19
We have observed that companies which we scored well on ESG metrics demonstrated relative resilience through COVID-192.
Labor practices have been in the spotlight – given greater focus on employee safety (particularly for essential workers) while others have been furloughed. In visible cases, investors helped reinforce positive ESG practices through engagement. For example, Insight's Global Chief Investment Officer wrote to key stakeholders in the economy, outlining our expectations and actions, including with regards to employee welfare and safety3.
As companies adapt, managing these long-term ESG factors appropriately can help create value for companies and their investors by optimizing their long-term credit metrics and consequently help them weather difficult times.
ESG is about resilience, not a fad – time to take it seriously
The goal of ESG in fixed income is to improve risk management with no extra cost, complexity or compromise.
We believe that simple ESG scoring alone is unsatisfactory. We see integrating credit monitoring and engagement into an investment and risk management process as essential.
We believe ESG can enhance a fixed income strategy and help any investor meet their return objectives with a higher degree of certainty.