The ESG Conundrum: Environmental, Social and Governance Factors for the Fixed Income Investor

  • 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.