- The Benefits of ESG Integration in Fixed Income
- Social Costs
- Looking at the World Through ESG-Colored Glasses
- Stakeholders with Different Needs
Implementing the use of Environmental, Social and Governance (ESG) factors into the investment process presents different challenges for fixed income and equity investors.
Many ESG ratings providers are centered on the concerns of equity investors. Fixed income investors have their own perspectives and concerns that may be inadequately addressed by the ratings providers.
Among the unique considerations for fixed income investors are the lack of ESG data on many issuers, the use of scores from equity-centric data providers, time horizons related to different maturities and the role of the issuer’s capital structure on the measurement of material risks.
Developing a complete picture of the risks and opportunities facing an issuer must include an examination of ESG factors. A successful implementation of ESG factors into a fixed income investment process requires a careful consideration of these differences. Acolytes of Benjamin Graham, Peter Lynch, John Moody and Henry Varnum Poors have long ignored or struggled with the thought of incorporating moral values and social costs into the valuation of a company’s cash flows. In recent years, the investment industry has developed a consensus that incorporating environmental, social and governance risks into investment valuation is generally consistent with fiduciary responsibilities. This approach has come to be called by the general term, ESG Integration.
ESG Integration, as commonly practiced, does not exclude companies based on attributes which are not considered to be material investment risks.
Unhappy with this constraint, many institutional investors have decided that due to moral values or social costs, they will not invest in companies that have business involvement in certain sectors, such as alcoholic beverages, or political entities, such as Sudan and Iran.
THE BENEFITS OF ESG INTEGRATION IN FIXED INCOME
One of the primary factors in the success of a company is having a comprehensive and accurate view of the risks facing that company. Companies that devote a great deal of resources to Enterprise Risk Management (ERM) should be better positioned to face challenges than more poorly prepared competitors.
In the same sense, investors who comprehensively understand the risks facing an issuer are better positioned to make proper relative valuation comparisons. The old phrase, “what gets measured, gets managed,” gives a window into why this is true. Firms and investors who are poorly prepared for unanticipated challenges that arise can be expected to react poorly.
It is particularly true in today’s low interest rate environment that one bad bond can ruin a portfolio. In a fixed income portfolio that has 100 equally weighted bonds earning 2% annually, a single bond dropping from $100 to $50 can wipe out a quarter of the annual income. An investor who ignores important information about issuers runs the same risk as chemistry students who only read the even-numbered chapters of a textbook. Developing a complete picture of the risks and opportunities facing an issuer must include an examination of ESG factors. Investment analysts who rely on the news feeds that appear on their Bloomberg terminals may very well miss a series of small adverse events that make it obvious that a company is poorly managed.
A company that places an importance on reducing worker injury metrics will be stressing adherence to proper processes. In mining, small missteps can be deadly and quickly mushroom into very large, costly events. That emphasis on managing proper processes reduces the financial risks facing mining companies, and their bondholders and shareholders. In fixed income, it is important to remember that credit ratings attempt to measure an issuer’s creditworthiness. Part of creditworthiness is an ability to withstand adverse circum-stances. Generally speaking, higher rated companies should be able to better withstand adverse ESG events than lower rated companies. At one point, BP estimated that the cost of the Macondo oil spill was $62 billion. These costs could have easily driven a smaller, lower rated peer into bankruptcy, leaving bondholders unpaid and in court hoping to get their money back. Because of BP’s financial strength and size, shareholders bore the full cost of this disaster. Had this happened to a smaller, lower-rated peer, shareholders could have lost everything, bond-holders could have lost everything and victims would be left suffering from uncompensated monetary losses.
For the same reason that the equity portion of a portfolio is expected to have a higher return than the fixed income portion, shareholders can stand to benefit the most and lose the most from ESG related events and trends.
Very few bondholders spend their nights dreaming of “10-baggers” On the other hand, the anchoring role that fixed income is expected to play in a portfolio can make under-performance painful.
SOCIAL COSTS
Societies have long struggled with conflicts between economic activities and the associated noises, smells and pollution.
The first person who cooked food over a fire probably had neighbors complaining about the smoke. The earliest academic literature on the social costs of economic activity primarily considered the actions of neighbors and subsequent changes in the value of property rights. As the economic study of social costs and their impact evolved, the regulation of these costs has become more likely. The societal costs of smoking, obesity and climate change have made angry neighbors of many of us. Social costs were the justification for early regulation of air and water pollution and have become the justification for today’s soda taxes.
The examination of long-term implications of social costs raise a time horizon difference between fixed income investors and equity investors. The long-term implications of social costs are far more important for Coca-Cola equity investors than for an investor looking at a three-year bond. Also, those long-term implications are far more import-ant for an investor in a thirty-year Coca-Cola bond than for the three-year bond.
Early socially responsible investors often avoided certain companies solely because of the social costs that companies were imposing on society, without the expectation that society would address the social costs.
There are certainly industries in which one can reasonably argue that increased regulation of social costs will impose costs on the firm, therefore making securities unexpectedly risky. Past investors in coal companies can certainly appreciate this. Buyers of McDonald’s and Pepsico securities must consider regulation of social costs into their investment process. On the other hand, changing regulations also present opportunities. Grupo Bimbo, a Mexican baked goods producer, successfully adjusted their product mix when Mexico’s 8% tax on snack foods went into effect.
One can now argue that looking at social costs as an investor is merely looking at long-term risks.
THE BENEFITS OF LOOKING AT THE WORLD THROUGH ESG-COLORED GLASSES
A careful consideration of ESG issues and social costs that are likely to be addressed in the near future by societies can frame an investment outlook.
For example, diabetes is taking an increased toll on societies and it is reasonable to think that action will be taken to address these increasing costs. According to the Centers for Disease Control, in 2012, “(a)fter adjusting for age group and sex, average medical expenditures among people with diagnosed diabetes in the U.S. were about 2.3 times higher than expenditures for people without diabetes.” According to the World Health Organization, the global rate of adult diabetes has risen from 4.7% in 1980 to 8.5% in 2014.
To capitalize on this trend, one might invest in the bonds of pharmaceutical companies working to address the health and mortality effects of diabetes. Looking at the diabetes issue as one of social costs to families and societies may lead to a different approach. Using the roadmap that led to a decreased use of tobacco in the developed world, it may be reasonable to expect increased taxation and restrictions on the marketing of certain products associated with the causes of diabetes. The International Diabetes Foundation (IDF) has published a “Framework for Action on Sugar” that advocates government incentives, including taxes, and marketing restrictions and regulations.
We may also expect consumer education and awareness to cause changes in consumption patterns. The IDF framework includes the advocacy of public health campaigns to educate the public on the health risks associated with excess sugar intake.
Changes in consumer behavior due to health concerns have a precedent. It may be useful to remember what happened with “Tobacco Bonds”, municipal bonds that were backed by future payments dependent on cigarette sales. Some Tobacco Bonds that were particularly sensitive to cigarette consumption trends suffered severe downgrades as consumption declined more than expected. Tobacco Bonds have become a substantial portion of the municipal high-yield market due to these downgrades.
Keeping in mind possible changes in consumer behavior, one may find better investment alternatives than a pharmaceutical company specializing in diabetes.
Companies in the consumer goods sector that are in the process of pivoting to benefit from those societal changes may prove to be a better investment.
STAKEHOLDERS WITH DIFFERENT NEEDS
A fixed income investor must be aware that the ESG data providers are focused on the needs of equity investors and their coverage universe.
The companies that are covered generally do not include companies that do not have publicly listed shares. This excludes broad swathes of the fixed income market. The existence of the excluded companies raises an interesting question. The data providers are, in part, grading companies on their disclosures to shareholders. One might assume that a privately-owned company, managed by the owners, has excellent disclosure to shareholders.
On the other hand, to whom does a government-owned corporation owe a duty of disclosure? Government bureaucrats or public citizens?
The arrival of a shareholder activist is expected to positively affect a stock price and negatively affect bond prices. Stock buybacks are generally welcomed by shareholders and despised by bondholders. Rare indeed is the bond investor who cares about the process for electing boards of directors.
There is an additional issue with the focus of the data providers on the interests of shareholders: the interests of bondholders and equity-owners are often at odds.
The fact that bondholder claims on a company are limited to the amount borrowed by the company (and interest due on the borrowings) may easily lead to different definitions of material investment risks. Bondholders care about the company’s ability to pay them back, shareholders care about the company’s ability to pay future dividends.
It is not unusual to see a company’s stock price rise or fall dramatically on a news article, while the price of the company’s bonds barely move.
ESG FOR SOVEREIGN, MUNICIPAL AND ASSET-BACKED SECURITIES
The fixed income universe also includes a wide variety of securities other than bonds issued by the for-profit corporations covered by the ESG rating agencies.
There are also bonds issued by non-profit corporations, such as universities. Sovereign bonds, asset-backed bonds and municipal bonds each have their own ESG consider-rations. For example, an investor looking at a thirty-year sovereign bond from a low-lying island nation would be remiss to ignore the risks of climate change. The same investor may want to consider governance risk by looking at Transparency International’s Public Sector Corruption Perceptions Index (PSCPI).
Analysts may want to differentiate between two different types of corruption. There is the type of corruption that arises from a government that fails to recognize individual rights and property rights, and there is the type of corruption that is used to facilitate government behavior. As a manager with Emerging Market debt mandates, we have long been concerned with both country and corporate governance, particularly with regards to property rights and corruption. We avoid companies that have significant operations in countries with absolute monarchies, dictatorships or “strongman” governments.
For example, we currently avoid investments that are based in Russia (135th on 2017 PSCPI), Venezuela (169th), and Turkey (81st) but we do consider investments in Brazil (96th) and Mexico (135th). At its very core, this avoidance is based on governance risk: the fear that the government will capriciously take away property rights.
Industry allocation within a sovereign nation that is perceived to be corrupt can be used to lessen that risk. Companies that have revenues primarily from government contracts can be avoided, with a preference for companies that primarily cater to retail customers. An investor may also express a preference for companies with many customers compared to companies with only a few customers, and for companies with revenue spread across several countries compared to companies with revenue from one country.
Most careful investors also consider governance risks when considering municipal and asset-backed bonds. Experienced municipal investors know that governance risk and credit risk go hand in hand. Late financial filings and a willingness to kick fiscal issues down the road are standard governance issues that are examined by muni bond analysts, as are labor issues that are considered part of sustainability risk.
ESG risks can also be material in asset-backed securities. Governance risk in asset-backed securities was a key trigger of the Great Financial Crisis. The inability of the sponsor to manage sloppy and fraudulent underwriting led to losses for many investors. Investors in securities backed by commercial real estate loans may use LEED Silver, Gold and Platinum status of buildings as proxies for evidence of the marketability of the underlying building.
This presentation is being delivered to, and is directed only at persons who are reasonably believed to be investment professionals, institutional investors, or other qualified investors. The presentation materials do not constitute as investment advice and should not be used as the basis for any investment decision. Any financial indices referenced as benchmarks within this presentation, are provided for informational purposes only. Materials presented are not intended as a solicitation or offer with respect to the purchase or sale of any security or other financial instrument or any investment advisory services. Reproduction of any part of this presentation without the approval of LM Capital Group, LLC is prohibited.
© LM Capital Group
Read more commentaries by LM Capital Group
