Sustainability in fixed income
Christoforos BikosDirector Manager Research
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Responsible investing (RI) is the term on every investor’s lips. So, to ensure you’re well-versed with the latest happenings in this space, each quarter, we’ll be speaking to a member of our Sustainable Investment Team about RI in the context of the LGPS. This quarter we spoke with Christoforos Bikos, a Director within our Manager Research team, about sustainability in fixed income (FI).
The evidence and rationale for incorporating sustainability into equities is reasonably understood and well-adopted by the LGPS, but this is less often the case in FI. And with growing FI allocations, the LGPS need to consider what can be done here from a sustainability perspective.
Is it possible to integrate sustainability into FI assets?
As an asset class, FI has a relatively large focus on downside risk management. Given that ESG analysis can help investors identify financially material risks, it’s increasingly common for FI managers to integrate ESG analysis into their fundamental bottom-up analysis.
The expansion of ESG within FI has led to the development of climate-focused or low-carbon funds, along with strategies that align with SDGs. At the most basic level, strategies may put in place an exclusion policy, which focuses on removing issuers partaking in controversial practices, such as unconventional oil and gas, or simply excluding high-emitting sectors, such as gas or utilities. The portfolio may also be tilted towards ESG and climate transition leaders, and managers may reduce the portfolio’s carbon emissions relative to a benchmark, such as WACI (or Weighted Average Carbon Intensity).
More ambitious managers have developed climate-aligned strategies with clear net-zero targets. For such strategies, the EU Action Plan on Sustainable Finance has developed recommendations for a climate transition benchmark (CTB) or Paris-aligned benchmark (PAB). CTB is less stringent, whilst PAB is more ambitious. A common feature of ESG integration is engagement, and whilst this has traditionally been associated with equities, more recently, there has been a recognition of the important role that FI investors can play in influencing corporate behaviour.
Is there a particular asset class within the FI universe that lends itself to the integration of sustainability?
Sustainable investment fund flows are down in 2022, but they continue to grow within FI despite difficult market conditions. Within FI, the investment grade (IG) asset class best lends itself towards sustainability and ESG integration, as most issuers are listed entities which are subject to higher disclosure requirements, leading to greater ESG data availability and “open doors” for engagement. In addition, the lower spreads on offer in the IG market make ESG analysis imperative to ensure that investors receive sufficient returns for credit risk. Moreover, IG bonds have longer maturities than sub-IG bonds, providing a greater time for ESG risks to materialise. ESG integration in structured credit has begun to gather pace but remains behind traditional corporate credit.
Can you provide a case study of how engagement has worked in practice in FI?
The issue: One of Redington's highly rated FI managers engaged with a Chinese technology company on its human capital management after the departure of several senior executives.
The engagement: The manager communicated their concerns with the company regarding the loss of talent, urging for the disclosure of human capital management indicators and talent retention policies, a proposal was put forward to the CEO to improve governance procedures and disclosure practices on employee diversity, inclusion and wellbeing.
Following this, the manager met with the company's head of corporate social responsibility and reporting team, and provided written feedback to the company’s ESG report, pressing for further strengthening of human capital management policies.
The outcome: As a result of these engagement efforts, the company released a human rights policy, aligned with the United Nations’s best practices, and issued a special report on how it was delivering on this policy.
As well as managing sustainability risks, is it possible to invest for impact within the FI asset class?
At present, labelled bonds provide the greatest opportunity for impact within the FI market. Labelled bonds, sometimes referred to as impact bonds, aim to deliver on environmental or social objectives. Green bonds are the most common type of labelled bonds; they raise capital to finance climate change solutions. A summary of the different types of labelled bonds available can be found in the following table.
Green Bonds
Social Bonds
Sustainability Bonds
Sustainability-linked Bonds
SDG Bonds
Transition Bonds
Guidelines
International Capital Market Association’s (ICMA) Green Bond Principles
ICMA’s Social Bond Principles
ICMA’s Sustainable Bond Guidelines
ICMA’s Sustainability-Linked Bond Principles
UN’s Practice Assurance Standards for SDG Bonds
n.a
General concept
Bonds issued to fund projects with environmental benefits
Bonds issued to fund projects with social benefits
Bonds issued to fund projects with environmental and social benefits
Bonds linked to predefined sustainability metrics (KPIs)
Bonds issued to fund projects with positive impact on UN’s SDGs
Provide financing to companies that are “brown” today but have the ambition to become green in the future.
Use of proceeds
Project categories according to the ICAM’s Green Bond Principles
Project categories according to the ICMA’s Social Bond Principles, including efforts to address COVID-19
Project categories according to the ICMA’s Green and Social Bond Principles, including efforts to address COVID-19
General corporate purposes
Projects aligned with SDGs
For “brown” industries that have financing needs and want to reduce their GHG footprint
Source: Unicredit research, November 2020
In theory, labelled bonds allow for the direct financing of environmental or social projects. However, there are examples of companies failing to use the funds for truly impactful projects. Hence, it’s imperative that the investor considers both the issuer’s sustainability profile at the entity level and, if applicable, the specificities of the project being financed. While labelled bond strategies exist, it’s more common for managers to allocate to labelled bonds within a broader portfolio.
Whilst a rapidly developing part of the FI universe, challenges still exist for labelled bonds. First, the relatively narrow opportunity set can result in sector and geographic concentration. Second, there’s a high concentration of issuance from quasi-sovereigns. Third, if a manager has to meet a certain quota of labelled bonds in their portfolio, they could become a forced buyer, resulting in them being paying a premium (or ‘greenium’) or buying bonds where the use of proceeds is not truly impactful. As the market matures and these issues are resolved, we expect FI impact funds to be offered as a standalone solution.
