What is a sustainable fixed income strategy? How does it differ from ESG analysis in equities? How can ESG criteria be incorporated into fixed income portfolios? Asset owners and fund managers are increasingly facing these questions, and things have finally started to move in this traditionally more conservative field.

The main focus of ESG investing has been on equities but it is now spreading more widely. Bonds constitute a substantial percentage of institutional investors’ assets. Pension funds in the seven largest markets own about $11 trillion in fixed income, which accounts for about 27 per cent of their assets. Insurance companies’ bond allocations tend to be even higher.

The world’s largest pension fund, Japan’s Government Pension Investment Fund started to incorporate ESG elements into its equity portfolio in 2017. It is now also looking at ESG in other asset classes. GPIF recently announced its partnership with the World Bank Group to identify leading ESG approaches used by international investors and service/data providers in fixed income. Due to the size of GPIF’s assets, $1.4 trillion, a main purpose of the project is to help investors deploy capital at scale in a more sustainable way.

Key differences
Applying ESG to various asset classes requires adaptation; for example, fixed income investing is very much a quantitative process. Managers find it difficult to include ESG criteria in their conventional financial models and are, therefore, often ESG-resistant. To highlight how some key elements of fixed income strategies are different from those in equities:

• The main focus is on risk analysis, i.e. the downside capital and default risk vs equities’ capital appreciation.
• Bondholder rights as opposed to shareholder rights
• The importance of sovereign and supranational issuers
• Dealing with securities of finite maturity
• Emphasis on cashflow stability and the use of bonds in liability-driven strategies.

Our research report, “Incorporating Environmental, Social and Governance (ESG) Factors into Fixed Income Investment” for the GPIF/WBG project, which involved an extensive literature analysis and structured interviews with leading players, found that ESG investing has finally gained momentum in these asset classes, especially in corporate bonds. Other fixed income asset classes, such as sovereign bonds, high yield, asset-backed securities or private debt have further to go.

Academic and industry research have been growing over the last few years to link ESG with financial performance in fixed income. It is now more widely accepted that ESG factors can constitute material credit risk and incorporating them in the investment process does not mean having to sacrifice returns. In practice, investors are trying to understand the link between ESG issues and traditional credit ratings; the ratings agencies need to enhance guidance.

Implementation strategies for ESG in fixed income vary widely. They range from purchasing thematic investments (such as green, social, sustainable bonds/funds) to following indices, hiring active managers and embedding ESG across the whole investment process. This can be done by following the methodology of specific service providers or by customising strategies with one’s own philosophy. Leading investors tend to have a full organisational approach (starting at board level) with clear ESG and climate-change objectives; however, smaller investors often find their options curtailed in practice.

From process to impact
One trend surprised us both in terms of the attention it is attracting and the pace of change. There is increasing attention to environmental and social outcomes (such as carbon emissions, environmental footprints and social indicators), going well beyond the traditional emphasis on ESG inputs and investment process.

More investors are seeking to extend ESG into impact investing or even merge the two. This is broadening from establishing dedicated impact projects/funds (typically of small size, such as social impact bonds) to attempts to measure the impact of portfolios on targeted environmental and social outcomes, including the UN’s Sustainable Development Goals (SDGs). How to do this is still a work in progress.

There are a number of general issues with ESG that apply to all asset classes being debated in the industry and academia. There are varying definitions, methodologies and ‘standards’, and a lack of transparency and comparability across providers. This is causing questions around who regulates sustainability. How is one to distinguish between material analysis and ‘green-washing’? ESG and climate change regulation are changing but remaining issues around fiduciary duty and ESG incorporation are still very much live. Finally, differing beliefs, especially in social and ethical matters, are not to be underestimated.

Fixed income’s unique obstacles
In addition, there a number of challenges specific to fixed income, including:

• What are material factors in terms of E, S and G for credit risk, and how do they change over different maturities?
• The relationship of ESG to other risks/opportunities, such as market risk, inflation risk and liquidity risk.
• How to organise engagement with corporate issuers for bondholders?
• Political sensitivities of, for example, exclusion of countries from sovereign indices/portfolios.
• Does it make sense for ESG to force an even higher portfolio concentration on the most developed markets? Some analysts now emphasise improvements in ESG in order to get exposure to higher yield, developing markets.
• Data for many fixed income instruments is still limited – in both quantity and quality – notably for smaller issuers and those in emerging markets.
• There has been a dearth of ESG index products and other ESG investment tools, compared with what’s in equities. This is changing and the two market leaders, MSCI and Sustainalytics, are complemented by new providers; for example, J.P. Morgan launched a new suite of ESG fixed income indices in 2018.
• There are also challenges in the green/climate/social/SDG bond markets, with demand outstripping supply.

Advancing ESG incorporation into fixed income portfolios will take more work. Progress in four main areas is recommended:

1. Governments and international organisations, but also corporations, should improve the provision of timely underlying environmental and social data. They can then be tested for robustness and materiality in ESG analysis.
2. Further rigorous conceptual work on ESG and fixed income is required and it needs to go beyond credit risk.
3. A refining of standard principles and metrics for applying ESG and impact investing is much called for. This will allow investors to customise their approach from a robust basis, to reflect their own beliefs and goals.
4. Finally, more innovative products could be rolled out to accommodate the growing demand for fixed income sustainable investments. They should be scalable and more diverse in order to become meaningful benchmarks and portions of asset allocation.

Georg Inderst is an independent adviser to pension funds, institutional investors and international organisations. Fiona Stewart is a lead finance sector specialist in the finance, competitiveness and innovation global practice of the World Bank.

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