ESG Integration and stewardship in fixed-income 

The global spotlight on environmental, social, and governance (ESG) concerns has intensified as the world grapples with complex challenges such as climate change, social inequality, geopolitical instability, inflation, and the aftermath of the COVID-19 pandemic. While ESG integration has long been associated with equity investments, there is growing recognition of its significance in fixed income portfolios.

The fixed-income market in its entirety is worth approximately $130trn, dwarfing the global equities market which is worth $42trn. Retail and institutional investors rely (sometimes heavily) on its features and benefits.

In this blog, we delve into the reasons why ESG considerations are just as vital for fixed-income investing, and how they can contribute to a more comprehensive analysis, enhanced risk management, and sustainable long-term performance.‍

First, what is fixed-income? 

Fixed-income is an asset class that provides investors with set cash flows on a predetermined schedule. When investors purchase a bond, they receive regular cash flows, known as coupon payments, based on a fixed interest rate. The principal amount is also fixed, and investors receive it when the bond reaches maturity.

This predictability makes fixed-income investments an attractive option for portfolio diversification. Governments with strong credit ratings are considered more stable and serve as a counter-balance to potentially riskier stocks. For investors seeking higher returns and willing to take on more risk, certain bonds offer the possibility of yielding greater rewards but come with an increased risk premium due to the issuer's perceived likelihood of default.

Corporate bonds, for example, are where companies issue bonds to raise capital for various purposes, such as expansion, acquisitions, or debt refinancing. They offer higher yields compared to government bonds, but they also carry higher credit risk, depending on the issuer's financial health.

How are ESG factors considered within fixed-income? 

Investors assess the ESG practices of issuers before investing in their bonds. Fixed-income managers conduct comprehensive analyses to understand the potential risks and opportunities associated with each investment. They evaluate how companies address ESG-related issues, such as carbon emissions, labour practices, board diversity, and overall corporate governance.

However, with some publicly-available information only being disclosed once or twice a year, coverage gaps are just one serious barrier to effective data management. Communication between stewardship teams, portfolio managers, and other responsible investment actors are increasingly necessary to fill in these gaps.

By incorporating ESG criteria, investors can identify issuers with sustainable practices and those better prepared to manage future challenges. This integration helps understand and mitigate ESG-related risks, supports investments in entities aligned with responsible practices, and can contribute to building a more sustainable and resilient fixed-income portfolio.

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How can ESG integration influence fixed-income portfolios?

Portfolio managers can use a range of methods to enhance a fixed-income fund’s ESG profile. The most common tools at their disposal include exclusions and tilting.

Exclusions
Exclusions in fixed income refer to the practice of omitting certain issuers or bonds from a portfolio based on specific ESG criteria. Investors may exclude entities involved in controversial industries, such as tobacco, weapons, or fossil fuels, or those with poor labour practices or human rights violations, such as those breaching the UN Global Compact principles. Additionally, issuers with weak corporate governance or inadequate disclosure practices may be excluded. By implementing exclusions, fixed-income investors aim to align their portfolios with their ESG and investment policies and avoid directing capital to companies or activities that do not meet their sustainability criteria.

Tilting
‘Tilting’ focuses on individual issuers rather than entire sectors, with fund managers able to remove specific issuers with low-ranking ESG scores from portfolios. This simply enables a fund to “tilt” towards more sustainable investments. Intentionally constructing a fixed-income portfolio in this way can signal a firm’s ESG convictions, without radically overturning a fund’s returns.  

Research by Insight Investments suggests that tilting a fixed-income portfolio away from issuers with bottom-quintile ESG scores can be done without having a material impact on the risk and return characteristics of a portfolio, can include tail-risk management (reducing downside performance) and in certain circumstances even improving risk-adjusted returns.  ‍

How does stewardship work in fixed-income investing?

Stewardship, which includes proxy voting and engagement with investee companies, is a method to promote good industry-wide ESG practices. Through asset managers and their clients (asset owners) taking part in constructive conversations with issuers, signatories to the UK Stewardship Code can identify, manage and influence ESG-related risks.

While bondholders may not possess direct voting rights, they hold a unique position as capital providers to companies, granting them direct access and communication with management. The staggering size of the global bond market underscores the significance of this influence.

Bondholders prioritise various aspects of company performance during their engagements, including business strategy, solvency, cash flow, and leverage, in addition to assessing how well the company manages ESG risks and opportunities. These engagements can address both short-term and long-term concerns that arise during the bond's term.

Bond managers with limited or no equity offerings collaborate with other bond managers to bolster their impact. Initiatives like Climate Action 100+, an investor-led climate engagement coalition, serve as facilitators, enabling bond managers to coordinate their engagement activities with other investors for more robust outcomes.

The importance of reliable reporting

Asset managers and asset owners need to clearly communicate the process and outcomes of their ESG integration and stewardship activities to their stakeholders. Regulators have been actively working to elevate the standards of reporting across the financial industry to promote consistency and guard against greenwashing.

However, reliable reporting is dependent on reliable and consistent data which helps inform investment analysis and decision-making. While challenges exist, efforts are underway to improve disclosures and to harmonise ESG data across the fixed-income marketplace.

In the UK, the Task Force on Climate-Related Disclosures (TCFD) framework is helping to inform credit risk analysis and issuer engagement for fixed-income investors and Credit Ratings Agencies (CRAs). According to the PRI, "There is a growing recognition among [fixed income investors] that climate-related financial disclosures should be embedded in bond valuations and that climate change can impact issuers’ probability of default."

More consistent, sector-specific, forward-looking and standardised reporting is needed. Fixed income as a whole lags behind the equities market, with challenges including coverage gaps, complex debt instruments, varying methodologies, and varying quality between data providers.

Why using a dedicated technology like Impactive is essential

We've seen above that there are so many moving parts when it comes to ESG integration and stewardship in fixed income. This is why using the right infrastructure to facilitate and streamline the process is so important.

The Impactive Platform allows your fixed income, equities, and stewardship teams to work together in a shared workspace, where important ESG information is curated and insights from engagements and proxy voting are shared. This helps to close knowledge gaps and enrich analysis.

Reporting becomes much easier and more reliable as all stewardship activities are evidenced and connected to investment decisions.

Why not book a free trial or demo to see for yourself?

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