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Sustainable fixed income investing comes of age

Multiple authors
2023-06-30
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Archived pieces remain available on the site. Please consider the publish date while reading these older pieces.

The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Key points

  • Growing awareness of how risks such as climate change can impact financial markets’ risk-adjusted returns is leading more market participants to embrace sustainability and sustainable investing as critical to the long-term health of global markets.
  • The sheer size of global fixed income markets and the variety of ways in which they touch the real global economy demand that the asset class be part of the broader conversation about ESG and sustainable investing.
  • The heterogeneity of the fixed income universe presents both opportunities and challenges for fixed income managers and allocators alike who want to make ESG and/or sustainable investing a priority.
  • From sovereign debt to corporate and securitized credit, each segment the global fixed income markets faces challenges with ESG and sustainability, yet each is at a different stage of its “journey” (some further along than others).
  • We believe it is essential that asset managers be able to tailor their approaches to ESG and sustainability to each particular fixed income sector in order to effectively address the challenges and opportunities therein.

Consideration of environmental, social, and governance (ESG) factors has increasingly come into the mainstream of investment conversations, both through routine incorporation into traditional investment processes and through distinct sustainable or impact styles of investing. Recent and current global conditions — including extreme weather events, the inequitable impacts of the COVID-19 pandemic, rising distrust of government institutions, and geopolitical challenges to a rules-based world order (such as the Russia/Ukraine conflict) — have accelerated this trend, highlighting the direct relevance of ESG and sustainability to understanding long-term market risks and opportunities.

Until recently, ESG and sustainability have been more of a focus for equity investors than for their fixed income counterparts. Encouragingly, that is beginning to change and doing so at a pretty swift clip too. Especially since the onset of COVID-19, ESG and sustainability have gained considerable traction among bond investors and, indeed, are now seen by many as integral to fixed income investing. For example, global sustainable debt issuance hit a new record high of over US$1.6 trillion in 2021 and is projected to keep climbing in future years (Figure 1). Notably, we believe that ESG integration and sustainable investing in fixed income necessitate a very deliberate, thoughtful approach — one that would vary meaningfully from one fixed income sector to another.

Figure 1
Sustainable-fixed-income-investing-comes-of-age-fig1

ESG and sustainability: The 30,000-foot view

At a high level, we believe that increased awareness of ESG and sustainability provides two key benefits to global markets:

  1. ESG integration helps market participants to think more holistically about the types of financially material risks and opportunities — for example, physical, reputational, and (geo)political — that should ideally be reflected in asset valuations and considered in the process of routine portfolio construction and management.
  2. Additionally, the dialogue around sustainable investing is leading more market participants to look beyond narrow, issuer-specific investment theses to consider how market participants’ behaviors are affecting the broader systems and structures (e.g., climate stability, strength of institutions) whose continued viability is so important for the long-term health of economies and markets.

Like many others, we firmly believe that a stable global climate, clean air and water for all, adherence to rule of law, strong institutions with broad public legitimacy, and broad-based access to economic opportunity are valuable public goods from which market participants would collectively benefit over the long term. Therefore, a central objective of sustainable investing is to help markets in aggregate evolve toward rewarding participants for exercising responsible stewardship of these public goods that are so critical to pursuing favorable long-term outcomes for the real people who are markets’ ultimate beneficiaries. Framing sustainability in this way underscores why fixed income is so pivotal to moving global markets and economies in a more sustainable direction.

Opportunities and challenges for fixed income managers

The size and heterogeneity of global fixed income markets presents both a compelling opportunity and a very real challenge for fixed income managers and investors who wish to prioritize sustainability and ESG.

As Figure 2 illustrates, the size of global fixed income markets makes them impossible to ignore in a conversation about ESG or sustainability. The diversity of these markets — spanning government bonds, corporate debt, and securitized assets from public as well as private issuers, and ranging from overnight to multi-decade maturity periods — means that virtually every facet of the global economy is somehow influenced by how fixed income markets function. Fixed income markets can impact real economic activity even more directly through the growing market for sustainability-linked bonds, whose performance may be linked to issuers’ deliverance on specific sustainable objectives deemed material to that issuer.

Figure 2
Sustainable-fixed-income-investing-comes-of-age-fig2

While the global fixed income markets are larger than the global equity markets, the growth of sustainable investing in fixed income space has lagged that of equities, even accounting for the growth of the sustainable bond market. As Figure 3 illustrates, assets under management (AUM) in active sustainable fixed income investment approaches still comprise a minority of total AUM in all active sustainable approaches. This suggests that there is a large untapped opportunity for such fixed income approaches to help effect more sustainable outcomes in global markets and economies. 

Figure 3
Sustainable-fixed-income-investing-comes-of-age-fig3

The vital importance of fixed income markets to sustainability and ESG is the source of both the opportunity and the challenge for this type of investing. The opportunity is that if fixed income investment managers innovate and engage now on sustainable disclosures, market best practices, and product designs, their efforts can make an enormous difference in how quickly markets and economies shift in a more sustainable direction. The challenge? Fixed income managers will need to be adept at tailoring their investment approaches to sectors with vastly different characteristics and starting points in their ESG and sustainability “journeys.” We believe asset managers with breadth and scale in fixed income investing, along with depth of collaboration between their fixed income and equity and public and private spheres, will be best equipped to successfully navigate this challenge.

Fixed income: Common challenges, different states of play

The ESG and sustainable investing styles that we recognize rely on many of the same inputs, including data and disclosures on material ESG metrics, agreement on which themes are material for the issuer’s business model or peer group, and issuers’ willingness to engage with investors on these themes. Investors can then use these common inputs to implement different approaches to ESG or sustainability, including: routine ESG integration; identification of leaders and “improvers” in adopting sustainable business practices; and determining if an issuer qualifies for an impact investing universe.

However, sourcing and applying these shared inputs is often easier said than done in fixed income. We believe this difficulty might be one reason why sustainable fixed income investment approaches have lagged their equity counterparts in recent asset growth and flows.

Across global fixed income markets, we have observed that investors face three fundamental challenges when seeking to deepen ESG integration and/or to develop sustainable investment strategies:

  • Data quality and disclosures;
  • Use of relevant evaluation metrics; and
  • Issuer education and engagement.

While these challenges are common to all fixed income sectors, managers need to adapt their approaches to ESG and sustainability sector by sector because each sector is in a different place on its respective “journey.” For example, some segments of corporate credit markets are quite mature in terms of investor activism, corporate awareness of ESG and sustainability, and data disclosures. By contrast, many securitized investors and issuers are still gaining basic familiarity with ESG and sustainability concepts and just beginning to define sustainable themes that are material to their sector (e.g., real estate climate risk, predatory lending).

The importance of having tailored approaches

For fixed income investors who wish to prioritize ESG integration or sustainability, we believe it is paramount to partner with an asset manager whose significant scale, global footprint, and breadth and depth of expertise — spanning fixed income and equities, public and private markets — can enable them to tailor their investment approaches to the unique realities of each fixed income sector. In our view, managers that can offer this type of tailored, sector-by-sector approach stand apart from the competition when it comes to:

  1. Conducting rigorous bottom-up analysis of material E, S, and G characteristics of individual securities in a given sector, including using proprietary insights from the manager’s knowledge of an issuer or sector to help make up for shortcomings in issuer disclosures and third-party data
  2. Growing the universe of securities for which there is a credible, research-based rationale for describing E, S, and G considerations that are material to the issuer, as well as for classifying the security as eligible for a sustainable or impact style of investing; and
  3. Scaling how this research is conducted and shared across investment teams to incorporate more varied types of securities into the manager’s sustainable and impact investing portfolios. Here are some examples of how we believe asset managers can differentiate their approaches by fixed income sector:

Here are some examples of how we believe asset managers can differentiate their approaches by fixed income sector:

Corporate credit

  • Data quality and disclosures: Sharing ongoing feedback with securities regulators and standard setters, such as the International Sustainability Standards Board (ISSB), to help shape rules and standards for improved data quality and clear, easy-to-understand sustainability disclosures.
  • Relevant metrics: Helping sell-side firms establish market “best practices” for different types of sustainable bonds. For instance, on “use of proceeds” bonds (e.g., green bonds), demanding clarity on the allocation of funds and robust governance around use of the bond’s proceeds. On sustainability-linked structures, ensuring that KPIs are relevant and that sustainability performance targets (SPTs) are material and sufficiently ambitious for the issuer (i.e., to minimize the risk of “greenwashing”).
  • Education and engagement: Coordinating on management and board engagement across fixed income, equity, and ESG specialist investors to get the most complete picture on how a given issuer’s ESG trajectory is likely to impact its entire balance sheet. Optimizing opportunities to engage with company management (Treasury and ESG) during pre-marketing of labeled sustainable debt offerings to espouse specific views and recommendations on companies’ sustainable practices/ deal structuring.

Sovereign debt

  • Data quality and disclosures: Leveraging proprietary insights and information advantages on sovereign issuers to overcome shortcomings in the quality of “official” ESG data and disclosures.
  • Relevant metrics: Defining material E, S, and G metrics that are relevant to forward-looking indicators of sustainable and inclusive economic development and to sovereign issuers’ willingness and ability to pay their outstanding debt.
  • Education and engagement: Seeking to broaden the scope of government stakeholders with whom to engage (beyond “typical” Central Bank or Finance Ministry contacts) and joining industry consortia, such as the Emerging Markets Investors Alliance, to amplify managers’ voices on material ESG or sustainable topics.

Securitized credit

  • Data quality and disclosures: Leveraging differentiated climate research to make more nuanced and localized assessments of physical climate risks that should be priced into RMBS or CMBS deals and drawing on expertise in collateral-level deal analysis to identify data (e.g., FICO scores) that could be relevant to assessing “S” or “G” considerations across deals.
  • Relevant metrics: Working with issuers to begin defining which metrics or practices should even be considered material in the context of ESG or sustainability (e.g., What constitutes predatory lending? How should a lender factor climate risk into loan underwriting decisions?)
  • Education and engagement: Bringing a full toolkit of engagement strategies, including leveraging equity, corporate credit, and private investing relationships to educate originators of securitized collateral on how ESG and sustainability apply to their businesses.

Final thoughts

ESG integration and sustainable investing are no longer the exclusive domain of equity investors. Although assimilation and adoption of these investing styles have historically been slower in fixed income than in equities, investor demand for sustainable fixed income solutions has swelled in recent years, particularly since COVID first struck in early 2020. Accordingly, the pace of new product and instrument innovation is picking up.

Over the long term, fixed income could even play a larger role than equities in reorienting global markets and economies in more sustainable directions. In addition to fixed income markets’ size and the variety of ways that fixed income touches the real economy, the burgeoning market for sustainable bonds allows investors to directly finance sustainable projects or to hold issuers accountable for their progress on specific sustainability metrics. Thus, fixed income may offer a more direct path to investing in a sustainable manner.

We believe the future looks bright for ESG and sustainability in fixed income investing. In some corners of fixed income, such as private credit investing and direct lending, market participants are still barely scratching the surface, but we believe there is tremendous future potential. From our perspective, looking across the global fixed income spectrum, we have every reason to think the benefits of such investing to markets in aggregate will become more apparent in the years ahead.

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