Consideration of environmental, social and governance (ESG) factors is becoming a key feature of bond pricing and credit-risk assessment – slowly.
Once the sole purview of investors, such consideration is earning a place on the agenda of credit ratings agencies globally. Given the weight ratings agencies carry in fixed-income markets, their heightened interest can give added impetus for ESG investment in different corners of the world, particularly where support for it is weak or where progress has recently stalled. The potential for positive impact is huge, given that global bonds – the largest asset class in capital markets – total nearly $88 trillion, Securities Industry and Financial Markets Association data shows.
Many investors are still questioning why they should incorporate ESG factors into fixed-income instruments, but more and more are also asking how to do it, and focusing on which factors might affect bond price performance.
Ratings agencies can play a unique role in enhancing ESG integration in financial assets, given that credit ratings feature highly among the factors investors consider when determining the suitability of a bond investment. Indeed, credit ratings cover most fixed-income instruments. They may define or limit investment mandates, and markets trade on potential credit rating upgrades or downgrades.
Better and systematic ESG integration in credit risk is important for fixed-income investors who buy bonds for capital preservation, particularly insurers and pension funds, which own considerable amounts of long-term fixed-income securities for asset-liability management, as in Australia’s well-established pension industry.
Evidence of a link between ESG factors and credit risk – the risk that a bond issue or its issuer will default – continues to emerge. As such, it is critical that these factors are systematically included in bond valuations where material. This issue is particularly pressing for asset owners, which have a fiduciary duty towards their beneficiaries.
On a positive note, fixed-income investors and ratings agencies are allocating more resources to ESG issues, including appointing dedicated analysts and publishing research. This is one of the main findings of Shifting Perceptions: ESG, credit risk and ratings – part 1: The state of play – a new research report by the UN-supported Principles for Responsible Investment (PRI). Investors and ratings agencies are also looking for new ways (internally or through external providers) to quantify and incorporate ESG factors more systematically into their risk assessments.
The report follows the 2016 launch of the Statement on ESG in credit ratings, which endeavours to enhance the systematic and transparent consideration of ESG issues when assessing credit risk. The statement, which is still open to new signatories, has already been endorsed by more than 120 investors representing more than $19 trillion in assets under management, and 11 ratings agencies.
More work to do
The agencies have yet to demonstrate, however, that refined methodologies and improved competence in ESG issues are prompting changes to credit ratings (some evidence exists, but it is patchy). Meanwhile, investors also have work to do, as ESG integration can often be advisory in nature and the responsibility may fall on ESG analysts alone to raise red flags, rather than on credit analysts or portfolio managers.
The report also highlights several disconnects between investors and ratings agencies, with the time horizon over which ESG factors are deemed material being the most contentious point. For example, ESG analysts tend to be more long-term than portfolio managers, while ratings agencies vary on this point.
Not all ESG factors are material to credit risk; some won’t trigger an issuer or issue default. However, all may negatively affect the trading performance of a bond and may become material in the future. For example, a company may meet the costs of an environmental accident easily, but if the frequency of accidents starts to increase (all else being equal), its financial strength may deteriorate.
Investors are asking for greater guidance from ratings agencies about the direction of risks. This is provided to an extent by credit watches, outlooks and outlook statements, but investors are demanding that the agencies become more proactive in addressing long-term trends, risk trajectories and their potential triggers.
Against this backdrop, several questions remain open that will shape the agenda of industry forums the PRI will lead over the next year. These will serve as a platform for engagement between investors and ratings agencies.
It is encouraging to see that the dial is beginning to move in the right direction, but more work lies ahead. ESG consideration is gradually gaining prominence, but still seems to be viewed as nice to have, rather than a must-have.
Carmen Nuzzo is senior consultant, credit ratings initiative, at the Principles for Responsible Investment.