Bonds can play a key role in ESG investing
Holding debt can be an effective complement to owning stocks.
As the world increasingly embraces responsible investing, the primary focus has remained on stocks of major corporations. It makes sense. A tenet of environmental, social and governance (ESG) investing is the ability to gain insight into a company’s ESG-related status and future goals. Most investors view equity ownership as the only viable way to engage with issuers on these points.
But recently, other financial instruments have been winning ESG investor attention, most prominently a company's debt. When compared to equity owners, corporate bondholders are in a unique position to inquire into the risks that may face a particular company, including ESG risk. Their status within the corporate finance structure is appreciated by boards and CEO’s alike, perhaps in some ways more so than that of those with proxy voting rights.
Today, the global bond market accounts for approximately $119 trillion in market value, according to the Securities Industry and Financial Markets Association. That’s significantly larger than the global stock market. But when you examine capital flows into ESG-labeled investment funds, stocks have dominated mindshare. A recent MSCI ESG Research report states that out of the 410 ESG ETFs they track in the market, 80% fit into the broad equity asset class, with less than 17% represented by the fixed-income category.
This statistic is remarkable because bondholders, especially large institutional investors, can play a significant role in assessing a company’s ESG profile and its potential for improvement. Credit investors tend to adopt a longer view when evaluating an issuer, poring over their filings, scrutinizing the balance sheet, examining legal contracts—all in an attempt to limit risk. Effectively, the long-established system of rating debt demands a company open up its books and operations to would-be creditors.
This level of transparency creates an excellent opportunity to evaluate ESG practices and concerns, many of which are not easily identifiable through a standard questionnaire and usually absent in a credit check. Primary research and insight are invaluable when it comes to smaller companies, municipalities, emerging-market businesses, collateralized asset-backed securities, private markets and others for which third-party data providers don’t offer sufficient, or any, reporting.
ESG ratings are proliferating these days, but many providers still focus on the largest publicly listed corporations and retain a low breadth of coverage in many specialized fixed-income market segments, such as municipals, liquidity management and even government-sponsored enterprises (GSEs). That is why we think many responsible asset managers need to come up with their own ESG assessments of issuers. Ideally, this should result in a proprietary view on how exposed the underlying collateral (such as bank loans and receivables or the sponsor) is to material ESG risks. When this is accomplished through direct high-touch engagement, it can be even more potent. Here, an investment firm employs sustainability subject-matter experts to lead the evaluation and complement fundamental research. It’s a lot easier to put these specialists in front of management and boards if the door has already been opened.
In the end, an investor who sprinkles an “impact” equity fund into their portfolio may be only taking a marginal step. Put it this way: If only 10% of a portfolio is in sustainable investments, is the remaining 90% “unsustainable”? As investors increasingly seek to have all of the asset classes in their total portfolios be ESG integrated, we believe the pendulum of responsible investment solutions will swing from equities to fixed income and beyond.