By Usman Hyat, CFA
There is increasing interest in environmental, social, and governance (ESG) issues, but how can investors apply ESG considerations to their decision-making process? Earlier this year, we conducted an interview with Jeroen Bos, CFA, to answer this challenging question in the context of equities. Today, we will try to answer the same question but for the fixed-income sphere. We spoke with Christoph M. Klein, CFA, who is a managing director, portfolio strategist, and head of ESG credit at Deutsche Asset & Wealth Management, based in Germany.
CFA Institute: What’s the case for considering ESG issues in fixed income?
Christoph M. Klein, CFA: ESG issues cover a broad spectrum of factors or key performance indicators (KPIs). These factors can have a material and relevant influence on the issuer’s credit quality. This should reduce future investment risks, given that potential future risks are analyzed and the inappropriate ones minimized. Some examples of these KPIs are product quality and safety, health and safety policies for workers and communities, and governance policies against corruption and bribery.
Real impact can be achieved through targeted ESG-compliant investment, as well as commitment from investors. Implementing ESG considerations in the investment process is a constructive approach to tackle such long-term and complex issues as climate change or working conditions in developing countries.
What are the different ways of integrating ESG consideration in fixed income?
There are three different ways:
- Exclude whole sectors like alcohol or weapons. Here, unclear grey areas remain. How about a supermarket selling alcohol? Why did you choose 5% as a limit for controversial turnover? Furthermore, there might be difficulties in portfolio construction when entire sectors or subsectors are excluded from the investment universe. This might result in unwanted biases and higher tracking errors.
- Take a best-in-class approach, sorting ESG qualities within every sector. The sector is investable but the investor chooses not to invest in very poor ESG issuers.
- Take a best-in-class approach, like above, but here the manager can invest in corporate bonds with poor ESG ratings only if: (a) the ESG risks (problems and critical incidents) are well known; (b) the credit spread is compensating for the ESG risks or better; and (c) there is confidence in future improvements of the issuer’s key performance indicators and ESG ratings, managing and avoiding or limiting critical incidents.
I recommend best-in-class approach that offers the flexibility in investing in poorly rated securities as it fully implements ESG considerations and leaves leeway for careful portfolio construction and active management versus all benchmarks. This process includes a dynamic forward-looking perspective. Best of all, engagement with the issuer and constructive challenging can yield ESG improvements and a have real impact (climate change, labor conditions, etc.)
Give us a practical example of explicitly addressing ESG considerations in fixed income?
We expected a significant credit spread tightening potential for the corporate bonds of a global mining company. Unfortunately, the environmental and worker safety standards had been weak, leading to a rather poor internal ESG rating. We started intense conversations with the senior management and got the impression that the company was working on those policies and standards to reduce or avoid critical issues and incidents in the future. We decided to invest given the constructive positive outlook. Since then the ESG quality has improved and the spread tightened even more than expected.
How does considering ESG issues in fixed income differ from that in equities?
The thinking, ESG rating methodologies, and their implementation in investment process and portfolio construction in equities and fixed income can be very similar. But in contrast to equities there is no proxy voting for corporate bonds but still enough room for engagement for example during management meetings.
To what extent are ESG considerations being considered in fixed income?
Given the complexity and relevance, all KPIs and themes are potentially linked to credit quality and are therefore a part of fixed income. We are surprised that the credit rating agencies are not incorporating KPIs more often and explicitly in their credit ratings. An increasing number of investors in the fixed-income space are demanding analysis and insights to reduce potential investment risks. Given the high demand for corporate bonds, we are unhappy that investors rarely get protective covenants, although they ask for them in the new issue process.
How feasible it is to engage with the issuers on ESG issues in fixed income?
Responses differ, and this is an ESG differentiator. A firm with clear policies and accountability, plus transparent reporting on ESG, might have a higher chance of performing better regarding ESG. Companies that discuss ESG risks openly tend to be committed and aim to improve further.
What organizational arrangements are needed to effectively consider ESG issues in fixed income?
Minimum standards in education amongst all investment professionals are crucial. Every analyst should know the most important ESG KPIs per sector.
It is helpful if an organization establishes a clear methodology as to how to assign ESG ratings across the global universe. Effectively handling gaps in the covered universe, like first-time issuers, is an important consideration.
Technology can be helpful to avoid missing critical incidents or controversial issues.
Having an ESG panel consisting of experts from diverse groups like clergy, academia, etc., does help deciding on complex grey areas.
It is very important that senior management of the asset managers and the clients understand that ESG is an important long-term concept and not necessarily likely to lead to outperformance in the short term.
What learning resources would you recommend on the subject?
I would suggest reading the following publication:
- “Corporate Bonds: Spotlight on ESG Risks” (Principles for Responsible Investment, PDF)
- “Capturing Growth in Adverse Times: Global Asset Management” (The Boston Consulting Group)
- “Corporate Environmental Management and Credit Risk” (S
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