ESG (environmental, social and governance) investing is rapidly growing in popularity as an investment theme around the world, and this couldn’t be truer than in Asia. ESG integration is a key component of fundamental research and is a theme that now features heavily across the spectrum of investment products.
ESG has its origins in the equity markets, beginning with religious, values-based or thematic— largely environmental — investors. Importantly, these measures helped to shift sustainable investing beyond purely norms-based ethical approaches (e.g., negative screening for tobacco or gambling stocks) and toward mainstream integration in the investment process.
Fixed income investors are today also increasingly incorporating material ESG factors into the assessment of credit risk. ESG is now more likely to be integrated into the mainstream investment process, as opposed to being seen as a specialist, segregated activity, confined to green bonds or serving as an add-on to the investment process.
Creditworthiness and cash flow generation
Fixed income analysis, at its heart, is concerned with the creditworthiness of a borrower — how likely that borrower is to pay interest when it is due and the probability of receiving the principal in full and on time.
The distribution of fixed income returns has a “fat tail”, meaning that the vast majority of fixed income securities pay their coupons and principal on time and in full, but a small minority default or need to restructure their debt obligations.
This is the main reason fixed income analysis focuses first and foremost on downside risks, unlike equity investing, where returns tend to have a more normal distribution.
The integration of ESG into fixed income considers several factors in the course of analysing, selecting and managing investments. For example: issues such as: climate change, sustainability, human rights, health and safety, rule of law and corruption.
ESG in fixed income
Even though fixed income analysts have for some time been taking account of ESG factors, whether implicitly or explicitly, it remains challenging to assess the impact of these factors in fixed income for a couple of reasons.
First, the time it takes for these factors to affect borrowers can often be lengthy; secondly the materiality of these factors needs to be determined in the context of the overall credit analysis.
For example, given decades-long trends in regulatory developments, it is clear that cars need to reduce harmful emissions. However, failure to do so has become a material credit risk only since the middle of the current decade, with tougher regulation (environmental), a change in consumer preferences (social), and companies employing questionable methods to meet emission standards (governance).
Similarly, it is widely known that many multinationals, including some popular household names, employ legal structures to minimize corporate tax payments. There have been several instances where increased media attention and changes in regulations have impacted those payments, and aggressive tax practices have provided an important signal regarding a high-risk tolerance on the part of a board and management team. However, up to this point, tax issues have apparently not affected demand for these companies’ products and services.
It remains to be seen if this happens in the future. Minimizing tax payments is not in and of itself a negative for credit but could have additional adverse effects on these companies’ business models in the future, especially as tax-related disclosure increases.
Dynamic analysis and clear strategy
For these reasons, ESG factors need to be reviewed regularly as part of the ongoing security monitoring process to access materiality and determine the time-frame in which they are likely to have an effect —positive or negative — on credit quality.
Integrating ESG considerations into the credit analysis process is just as important as trying to determine whether the leverage of a company is likely to increase over the next two to three years.
The wide variety of potential ESG factors combined with the enormous diversity of entities that issue fixed income securities, along with the range of securities each entity can issue, pose challenges when integrating ESG factors into fixed income analysis.
Investors need to develop a clear strategy and a framework that can assist analysts in identifying and quantifying the risks and opportunities. We believe that the approach must be dynamic, as overreliance on a static list of criteria and decision trees will likely result in suboptimal investment outcomes.
Most ESG factors represent potential downside risks. Likewise, fixed income research generally emphasizes downside risk management over upside potential. From this perspective, integrating ESG factors into the fixed income analysis process can be relatively seamless.
Another similarity is that credit quality deterioration is most often a gradual process in the case of both ESG and more classic fixed income risks. Pressures build within the debt structure, which at first may appear immaterial and can remain that way if the borrower takes remedial action. However, sometimes the pressures mount gradually over time until the debt burden suddenly becomes unsustainable and the structure collapses.
In classic fixed income investment analysis, investors look at financial variables to determine whether pressures are building in the debt structure, but it remains nearly impossible to predict the particular chain of events that drives an issuer to bankruptcy. Similarly, when looking at ESG factors, pressures can develop gradually over time and become material, e.g., an independent board of directors can become less independent, benign products used in the production process can be replaced with harmful products and tax avoidance schemes can be put in place.
The pressures from ESG factors can sometimes be mitigated with actions, but sometimes they build quietly within an issuer, then mushroom or coincide with a change in the operating or regulatory environment. A confluence of events then leads to a severe deterioration in the sustainability of the borrower.
Determining the effect of the time frame and materiality of ESG factors on an issuer’s credit quality is complex and difficult to model. The interplay between various factors can be relatively straightforward until a sudden change occurs, as described by catastrophe theory. It’s like trying to model how high ocean waves will rise before they crash.
Incorporating ESG into fixed income in the long term
There is a high level of ESG awareness and increasing ESG factor integration among fixed income managers. More and more ESG integration is being driven by the rationale that as a part of credit analysis it should provide a more comprehensive picture of a company’s outlook and long-run sustainability.
Assessing ESG in the context of overall credit risk is complex and requires that investors understand the array of potentially material ESG factors, as well as the time frame within which they are expected to factor into a borrower’s credit quality. The changing nature of ESG factors makes a formulaic approach with set criteria suboptimal. Incorporating ESG criteria into the analysis process can be a point of differentiation among managers, often leading to more appropriate compensation for existing risks.
The dynamic nature of ESG factors and their effect on borrowers’ risk profile and opportunity set points to the benefits of active management. An active approach allows fixed income investors to develop an understanding of borrowers from the viewpoint of various stakeholders and provides a means of accessing and engaging with management. In our view, the result is a better-informed investment decision.
In addition, clients in all regions, including in Asia, are asking for greater transparency and accountability vis-à-vis ESG factors. There is a strong investment case for the integration of ESG into the credit evaluation process — and a client driven business case, which is likely to continue to propel the industry forward in this regard.
The range of different types of ESG risks and opportunities, and the impossibility of quantifying their effects in a hands-off, objective fashion, means that incorporating ESG factors into fixed income investment analysis is best accomplished via active management.
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