Embedding engagement in the fixed income investment process

Engagement by fixed income investors should not be seen as a standalone activity but as an integral part of a responsible investment approach . as both a source of information for investment research, and a way to directly influence the issuer’s management of ESG risks and opportunities. Thus, the research used to identify cases of engagement will be continuously integrated with the insights gained during the dialogue with companies and incorporated into investment decisions.

From an operational perspective, there are a range of different approaches investors can take to engagement. Engagement can be:

embedded in the investment process and conducted by credit analysts and portfolio managers;
conducted by a dedicated engagement team specialised in ESG themes; or
integrated, whereby ESG specialists help flag engagement topics and conduct engagement alongside fixed income practitioners.

Examples of approaches to engagement
Investor	Highlights
Hermes Investment Management, Investment Manager, UK	In addition to analysing and pricing operating and financial risks, the Hermes Credit team also considers ESG factors when making investment decisions. To inform its discussions with issuers, Hermes Credit relies on several inputs: First, from a more general perspective, along with the rest of Hermes, the credit team relies on the responsibility team for firm policies, approach, and investment tools. When focusing on a company-specific level, the team reviews Hermes’s proprietary measures of ESG risk . their QESG scores . which represent a good snapshot of the company’s overall ESG performance. This score is supported by the company information provided by Hermes’s engagement team, Hermes EOS, because the dialogue with the company provides the context of the QESG score. For example, is the company on the right trajectory, or is it more on a negative path?
MN, Investment Manager, Netherlands	MN’s credit analysts regularly review public reporting and/or cross-check and verify third-party research. Credit analysts discuss their findings with other members of the credit team, responsible investment and governance team, and equity analysts. They consider whether the issue has already been identified and if there has been any engagement, and, if so, what the outcomes were. Credit analysts lead on engagements as they know the companies best, and keep relevant parties (credit team members, responsible investment and governance team, equities) updated on the engagement progress.

Regardless of who ultimately leads an engagement, it is considered best practice to keep relevant internal functions (risk, credit, responsible investment, corporate governance, equities teams etc.) updated on the progress and outcomes of the engagement, to ensure findings are incorporated into investment decisions. Leading investors have developed practices to ensure that information and insights collected through engagement can feed into the investment decision-making process such as:

ensuring regular cross-team meetings and presentations;
sharing engagement data across platforms that is accessible to ESG and investment teams;
encouraging ESG and investment teams to join engagement meetings and roadshows;
delegating some engagement dialogue to portfolio managers;
involving portfolio managers when defining an engagement programme and developing engagement decisions;
establishing mechanisms to rebalance portfolio holdings based on levels of interaction and outcomes of engagements; and
considering active ownership as a mechanism to assess potential future investments.

Examples of investment outcomes
Investor	Highlights
Neuberger Berman, Investment Manager, US	Following its engagement with a pharmaceutical sector issuer over material ESG issues such as drug pricing and ethical practices, Neuberger Berman continued to monitor the company as a potential investment. During a follow-up engagement a year later, it discussed the reasons it had previously passed on the investment opportunity with management, who were still unable to placate Neuberger’s concerns about pressures on drug prices and the growing public scrutiny of pricing practices. The company’s balance sheet was low on tangible assets and its R&D spending would, in Neuberger Berman’s view, not be able to sustain the company for the long term. Because of these factors, the investor once again declined the opportunity to invest. As the increased international focus on drug pricing persisted, the company’s cash flows came under heightened pressure, ultimately leading the company into discussions to restructure its debt through a bankruptcy process. Neuberger Berman’s focus on engaging over material ESG issues allowed it to protect value for its investors by avoiding this credit deterioration.
KfW, Asset Owner, Germany	KfW influences issuers’ ESG practices indirectly by informing them that their ESG profile has a direct impact on investment decisions. For its liquidity portfolio, KfW only invests in bonds of issuers whose sustainability score is among the best 80% of the respective sector. Since 2011, it has sent letters each year to issuers in its investment universe to inform them of KfW’s investment approach and the issuer’s current ESG score. A poor score means KfW reduces its investable limit in a single issuer. As a result, KfW has anecdotal evidence that it has driven better management and disclosure on ESG by some issuers.
QIC, Investment Manager, Australia	After its engagement with an Asian automaker issuer, QIC continued to monitor the company for developments in the material areas of concern identified through the meeting: its product carbon footprinting performance, management of labour disputes, and poor governance profile. When the company issued a new bond three months later, QIC’s credit analysis showed that the pricing of the new bond did not adequately compensate investors for the current ESG risks and broader credit risk. As a result, QIC declined to participate in the primary market deal, giving feedback to the syndicate and company that it had not seen sufficient progress on the matters raised in the engagement meeting to warrant further investment.