Integrating ESG into Fixed-Income Portfolios

While some investors, hedge funds, and even whole regions continue to waver among skepticism, technical uncertainty, and outright opposition to environmental, social, and governance (ESG) considerations, large asset owners are now moving to implement ESG investing throughout their portfolios, including allocations to fixed income.

Christoph M. Klein, CFA, of Deutsche Asset & Wealth Management, spoke at the 68 CFA Institute Annual Conference about how integrating ESG factors into fixed-income analysis can reduce idiosyncratic and portfolio risk and improve portfolio performance.

So what has propelled the ESG strategy into mainstream investing? Vocal public discourse has helped together with a stream of research papers emphasizing the disadvantages of not taking the long-term over the short-term view and tangible benefits from re-aligning investment processes with sustainable business practices.

In this Q&A session which followed his presentation, Klein considers how ESG can be applied and how ESG approaches can help fixed-income investors anticipate and avoid investments that may be prone to credit rating downgrades, widening credit spreads, and price volatility.

A full version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly.

Audience member: Is the widespread pressure to adopt ESG mandates driven by ethical reasons or a desire to reduce portfolio risk?

Christoph M. Klein, CFA: Both are very important reasons to implement and integrate ESG in portfolio management. More sponsors demand a higher focus on ethics and reputation, and I believe this demand will continue to grow. Regarding the second motivation, various studies and examples show that ESG KPIs [key performance indicators] are relevant to assess single investment risks but also for overall portfolio risks.

Is it best to apply ESG factor analysis to equities, which have unlimited upside, rather than to fixed income?

Equities normally do have more upside potential than bonds, but bond investors are focused on downside protection and spend a lot of time thinking about potential risks — especially investment-grade fixed income, which has an asymmetrical return profile; an investor can earn 3% on the upside but lose 90% if something goes very wrong. The equity risk–return profile is more symmetrical. But overall, the inclusion of KPIs in an analytical framework to forecast potential risks is an important consideration not only for bond managers but also for all investors.

Does corporate governance have the same impact on fixed-income returns as it does on equity returns?

Yes. Petrobras is a recent example of how governance can have a huge impact on a company’s credit spreads as well as on its equity price. The corruption allegations and unexpected writedowns led to a reduction in trust.

In Asia, where investors are very bullish on demographics and growth potential, governance is sometimes an issue because it has not been a focus of investor scrutiny in the past. Some Asian companies are still family owned with limited transparency. Ambiguity in bankruptcy laws may also exist.

Investors should always be cautious of region-specific issues, which is another reason that meetings with management are helpful. If, for example, management promises to keep a stable credit rating, but three weeks later, it engages in a large acquisition and the rating moves down three notches, an investor has reason to be skeptical of future claims. Good research coupled with an understanding of management can give a clearer picture about a company’s governance issues.

Is it possible to isolate the effect of ESG factors from the other factors that affect fixed-income performance?

ESG KPIs can be sorted by materiality and relevance for different sectors. For example, consider a brewery based in drought-stricken Southern California that has issued a 10-year bond. This brewery may run into water shortage issues down the road. Generating an isolated sensitivity analysis might be difficult because extenuating factors may exist. The brewery may have large water reserves in San Francisco, for example, enabling it to survive a little bit longer. All factors need to be considered in an analysis. Isolating the impact of ESG factors is not that easy.

Can ESG analysis be applied to sovereign bonds?

Yes, but the KPIs required for sovereign bond analysis differ from corporate analysis. Sovereign bond KPIs might include diversity, gender gap, existence of a death penalty, biodiversity, environmentally treated climate change, infrastructure, and labor force participation ratios. But although the factors to consider are somewhat different from those factors analyzed for a corporate bond, the investment process is similar.

Are the credit rating agencies that are signatories to the PRI initiative mandated to report ESG risk factors in their credit rating reports?

Unfortunately, transparency regarding the integration of ESG factors into credit rating reports has not yet occurred among the rating agencies. Such transparency would be an important step in industry acceptance.

Under the strong form of the efficient market hypothesis, why would a stock’s price not reflect all available information, including ESG risk factors?

I am not a big believer in efficient markets. I know of many instances when information was not reflected in a stock’s price for several weeks despite a new analytical framework or a new dataset becoming available. ESG investors need to be resilient and patient. Some ESG themes will be realized in time; others will be difficult to forecast. I am optimistic that ESG investors will benefit and outperform.

Do performance data exist that prove that ESG integration enhances performance in the long term?

I would like to highlight one empirical study: “Corporate Environmental Management and Credit Risk,” by Rob Bauer and Daniel Hann. The study presents clear evidence that (1) environmental concerns are associated with a higher cost of debt financing and lower credit ratings and (2) proactive environmental practices are associated with a lower cost of debt.

Is it true that some ESG researchers rated BP quite highly prior to the Deepwater Horizon accident?

Yes, and this type of rating is a big criticism of the ESG rating industry. The problem is that with 200 KPIs, the weighting of a single KPI is comparably small. Even if there had been three or four warning indicators for BP, their combined weighting might not have lowered the overall score enough for a sell recommendation to be triggered.

Do shortcomings exist in the data quality of ESG indicators?

Yes. Extracting the data is difficult, and management teams are not always forthcoming with information. For example, a particular utility company in northern Germany is proficient in alternative energy technology, but it does not provide detailed reporting of its KPIs, so it is viewed in a negative light. Operationally, it is doing a good job, but it is not yet able to report KPIs in full detail.

Is it possible to buy off-the-shelf ESG information?

Some investment firms do buy ESG research, and they incorporate the ESG score along with the credit rating according to their internal scaling mechanism. They may do a best-in-class sector analysis in weighting and ranking. But these efforts fall short of a more comprehensive analysis based on reading an issuer’s ESG report, identifying its worst KPIs, and determining what it is doing to address any ESG issues. The reports themselves are fairly short, maybe three to seven pages on average, but the information they provide on an issuer’s ESG issues is quite valuable.

Is the focus on short-term performance one of the reasons institutional investors have been slow to adopt ESG?

Yes. It takes a lot of patience and resilience to be an ESG investor. Nonetheless, I believe strongly that ESG matters will become much more important going forward, even though it may take years or even decades to see the results. Some investors will argue that not everyone can wait a decade. But investment managers who do not underperform should not be adversely affected by the wait.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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