Fixed income investing: delivering returns and achieving outcomes

ESG incorporation best practice

Once the sole purview of equity investors, responsible investment practices are now on the agenda of many of their peers in the debt markets. Indeed, responding to increasing demand from signatories, the PRI now runs five fixed income workstreams, compared to just one in 2016. The diversity and complexity of the asset class – with various types of borrowers, instruments, legal structures and maturities – brings unique challenges when incorporating environmental, social and governance (ESG) factors in investment decisions. It necessitates a differentiated approach from equity investing in certain cases, but it also offers a greater range of techniques and opportunities.

Leading practice in fixed income

Fixed income investors approach responsible investing from different angles. Some focus on risk mitigation (including default risk). Others are outcome driven and may invest thematically or target specific environmental and/or social objectives. In doing so, they might buy ‘ESG-labelled’ bonds with clear use-of-proceeds or performance targets.^[1]

These approaches are not mutually exclusive and may involve the same implementation practices (for instance, exclusion or engagement). How investors incorporate ESG issues depends on various factors. For example, asset owners have more discretion on the scope and objectives of their investment mandate than investment managers. Investment time horizons and holding periods are also important: for short-dated bonds or those not held until maturity, time horizons may be too short for ESG risks to materialise or for an outcome-driven investment approach to be relevant.

Regardless, there is a recognition among many fixed income investors that, while ESG risk factors (especially governance) have traditionally featured to an extent in fundamental credit analysis, ESG integration needs to be made more explicit and embedded systematically throughout the investment process. Recent regulatory changes, notably in Europe, are adding impetus to this shift. Simply buying an ESG-labelled bond does not make an investor ‘responsible’.

What others can learn from the asset class

Investment decisions using fixed income instruments are less binary than those for equity investors. They are more multi-dimensional, requiring nuanced ESG considerations as investors fund different components of an issuer’s capital structure, relating to obligations over multiple maturities, and with different income profiles. Fixed income investors do not just finance corporates, but also public entities, including central and local governments, supranational organisations, agencies and state-sponsored enterprises.^[2] Such entities often provide critical services with a social component (e.g. education, healthcare or housing) or oversee management of natural resources, thus offering unique opportunities to contribute to positive environmental and societal outcomes as well as reduce negative ones.

There is scope for equity investors to collaborate more closely with debt investors, to take advantage of complementary characteristics and opportunities. The work the PRI is promoting to facilitate disclosure and create new norms for proactively sharing ESG information among private equity and debt investors goes in this direction, as does encouraging more bondholders to join the Climate Action 100+ initiative.^[3] Engagement efforts could be better coordinated, reinforcing asks, using different channels to approach the same entities and, where possible, leveraging bondholders’ direct access to government officials, index providers and nongovernmental organisations. Engaging with sovereigns is important not only because national policies affect public accounts (and hence sovereign credit risk), but also because they determine the business environment within which corporates operate.^[4]

There is scope for equity investors to collaborate more closely with debt investors, to take advantage of complementary characteristics and opportunities

Barriers to greater ESG integration

Whilst shareholders also face ESG data obstacles, these may be even greater for bondholders, who may have different data needs,^[5] reflecting the sheer diversity of sub-asset classes within fixed income (e.g. private debt, public debt, securitised credit, alternative debt, etc.) In addition, engagement can be more challenging for debt investors as they lack equity holders’ voting rights.^[6]

Attempts by fixed income investors to apply ESG factors to strategies managed against a non-ESG benchmark can potentially lead to larger tracking errors. How benchmarks are constructed may also be an issue: the bias is towards issuers with better liquidity, rather than those with higher ESG quality. The limited availability of ESG fixed income indices presents further constraints.

Finally, while the scope to invest for impact is expanding, with growth in the ESG-labelled issuance market, this is from a low base. As such, there remains insufficient diversification in the issuance of different types of ESG-labelled bonds, whether by domicile, currency or type of issuer.

What next?

With global debt at record highs,^[7] fixed income investors have a unique opportunity to embed sustainability considerations systematically in their investment decisions. This could be either via using increased ESG scrutiny at different stages of the investment process, depending on the nature of the debt that they are funding, or by being more proactive and engaging with borrowers to seek clarification around their funding policies, strategies and goals, or by working on new original lending solutions.

The debt market has already undergone a period of creative innovation with regards to ESG features, as evidenced by the emergence of the ESG-labelled market, initially with use-of-proceeds issuances, and now with debt instruments linked to ESG performance. This will only continue and, indeed, will need to accelerate the urgency and enormity of the sustainability challenges the world faces. The supply of solutions addressing systemic risks such as climate change, as well as emerging ones linked to nature and biodiversity, needs to increase.

The debt market has already undergone a period of creative innovation with regards to ESG features, as evidenced by the emergence of the ESG-labelled market, initially with use-of-proceeds issuances, and now with debt instruments linked to ESG performance

This effort can be aided by fixed income investors supplying more funding ‘with ESG conditions’ to meet, and the use of standardised ESG frameworks to increase investors’ and issuers’ accountability, and to promote best practice by specific instrument types. Doing so offers more opportunities to combine risk mitigation with investment choices that help shape real-world outcomes.

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].