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    What is responsible investment? An introduction

    What is responsible investment? An introduction

    May 04, 2021 Fixed income, Responsible investment

    Investing responsibly is now mainstream

    Investors increasingly expect their portfolios to be managed to take environmental, social and governance (ESG) factors and risks into account – and investment managers have flocked to meet this demand.

    Signatories to the UN-supported Principles for Responsible Investment (PRI), the world’s leading proponent for responsible investment, account for tens of trillions of dollars of assets under management, of which $38 trillion is in fixed income1.

    Fixed income players have made significant progress in taking ESG factors into account. The industry has launched fixed income indices focused on ESG-related bonds, and industry initiatives are generating useful research materials and encouraging further innovations.

    The PRI’s multi-year Credit Risk and Ratings Initiative is one of the most prominent. It aims to “enhance the transparent and systematic integration of ESG factors in credit risk analysis” by facilitating dialogue between credit rating agencies (which are crucial players in global bond markets) and investors2.

    The growth of the impact bond market has been another notable development, whereby issuers use bond proceeds to finance projects with environmental and/or social benefits. Issuance exceeded $1 trillion for the first time in 2020, and demand continues to outstrip supply.

    Three key questions for fixed income investors

    1. What is responsible investment?

    The PRI defines responsible investment as an approach to investing that aims to incorporate ESG factors into investment decisions, to better manage risk and generate sustainable, long-term returns3.

    In practice, research into ESG factors may also depend on, or lead to, active engagement to better understand relevant risks and how they are managed.

    In our view, responsible investment is about managing risk. It is not about putting specific ethical considerations ahead of other criteria.

    This sets it apart from approaches like sustainable or impact investment, which aim for non-financial, as well as financial, objectives (see Figure 1).

    While terms such as ‘ESG investing’ and ‘ESG portfolios’ are often used, there is no common definition. They may be used to refer to responsible, sustainable or impact approaches, or other styles of investment that seek to incorporate ESG factors to some degree.

    Figure 1: Differentiating between responsible, sustainable and impact investment4

    2. What does it mean to invest responsibly in fixed income?

    Fixed income investors are focused on reducing the risk of default. We believe a responsible approach will therefore reflect any material risk – including ESG-related factors – that could affect whether an issuer fulfils its interest and capital payment obligations.

    Unlike equities, which represent ownership in an enterprise that could survive indefinitely, most bonds have the potential to pay regular coupons over a specified period, then pay out principal at a pre-set maturity date.

    This means that, whereas in equity markets, ESG factors typically relate to sources of corporate profits, in fixed income they typically relate to an issuer’s creditworthiness.

    ESG factors can vary for different bonds, even if they are issued by the same entity. In our view, a bond due to mature within one or two years is likely to bear less ESG risk than an equivalent bond due to mature in 30 years.

    A responsible investment approach will therefore be especially relevant for longer-term strategies, where a fixed income portfolio aims to hold debt issues until maturity, rather than a traditional strategy which will buy and sell issues over time in pursuit of its performance target.

    3. How can fixed income investors actively engage on ESG issues?

    When it comes to engagement, headlines typically focus on shareholders’ voting powers, which enable them to influence – and if necessary replace – company executives.

    We believe, however, 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.

    Failing to satisfy bond markets’ expectations will lead to the entity’s cost of borrowing to rise, and so bond investors frequently have access to senior management and key stakeholders, with often regular opportunities for dialogue.

    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.

    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 financial or sustainability objectives.

    To find out more about how Insight invests responsibly, visit our responsible investment page.

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