Opportunities grow to help fixed-income investors use ESG

Asset owners are integrating environmental, social and governance views into their fixed-income portfolios, but aligning bond portfolios with ESG principles can be complicated.

Joshua Palmer, the head of sustainable credit research at Willis Towers Watson PLC in London, said incorporating ESG views into a fixed-income portfolio starts with two steps.

"Step one is recognizing that ESG risks and opportunities are relevant for fixed income. And step two is seeing that you have influence. It may not be as concrete (as with equities) but you can definitely engage on behalf of your clients and help reduce ESG risks and see opportunities that way," he said.

There are challenges in managing and evaluating ESG-related risk and return that vary across each fixed-income asset class, Mr. Palmer said. But even highly complex fixed-income instruments, such as asset-backed securities, can be evaluated for ESG opportunities.

"If you're looking at an ABS portfolio, which has a variety of different underlying loans, then the origination practices on the social side or weak loan servicing models could be more impactful to the risk and return potential of the asset. And not only do you have different underlying borrowers, you have different maturities, different time horizons, potentially, where the risks could play out," he said.

Mr. Palmer said evaluating securitized vehicles using ESG criteria comes with complexities but innovative opportunities are arising, such as blended public-private finance projects that securitize portions of community development loans.

"It's an interesting way of leveraging public capital to get more private investors involved in development projects. It's something that I'm seeing more and more, with very strong impact credentials. I think it's quite an innovative structure. There are some challenges with assessing the actual risk within those structures. But I think it looks like it's an area that's set to grow," he said.

He also pointed out the complexities in measuring the risk and return potential of sovereign debt.

Mr. Palmer said weighing risk and identifying potential opportunities in this space require an examination that considers multiple, nuanced factors.

For example, "If we look at Colombia, and other countries, a lot of the revenue and royalties that are raised from oil are used for social and peace projects. Colombia redistributes a lot of that income to help with poverty. If that revenue falls, then there's not going to be as much support to help with those social issues," he said.

However, the potential impact of social uprisings, social instability, or even the impact of carbon emissions in some markets are important risk factors to consider, he said.

Mr. Palmer mentioned the downgrading of Colombian debt in early 2021 following protests and social unrest, which impacted the government's plan to service its debt.

Regional preferences add further complexity to applying ESG criteria to fixed-income portfolios, Mr. Palmer said.

"In the U.K., we have a lot of regulation that's impacting our clients. In Australia, there's a focus on modern slavery in supply chains. And in the U.S., social and inclusion and diversity aspects are exceptionally important," he said.

Mr. Palmer said ESG trends may be different across regions but they could be seen as part of a long-term trend toward social progress, so it's important to consider the broader range of metrics, even when there are pronounced regional interests.

Ashley Schulten, a managing director and head of responsible investing, global fixed income, at BlackRock Inc. in New York said: "We canvass our global investors to understand what it is they want to express within ESG-tilted fixed-income portfolios, and then we build the tools to help them do precisely that."

As an example, Ms. Schulten said some BlackRock clients have asked for ways to express an ESG-tilted view through investments in the U.S. municipal bond market.

"There are public transport projects, water-saving projects, public housing opportunities — all the sorts of things that clients interested in external impact want to fund. Our muni team evaluates investments to see how they are lending themselves to, for example, an environmental or social benefit to a third party, and then we adjust those exposures accordingly," she said.

Ms. Schulten said active credit managers can better evaluate ESG factors and understand how those factors affect the financial risk and reward of the holdings they manage through a variety of datasets. She cited data, for example, from organizations such as the Transition Pathway Initiative, an asset owner-led effort that assesses companies' preparedness for the transition to a low-carbon economy; the Science Based Targets initiative, which helps companies set science-based emissions reduction targets; and MSCI Inc.'s set of Implied Temperature Rise metrics, a forward-looking metric designed to show the temperature alignment of companies, portfolios and funds with global temperature goals.

"As an industry, especially around climate, we are moving from a place where we're reliant on a snapshot of a company today to one that is much more forward-looking," she said.

Ms. Schulten said the forward-looking evaluation of data can include factors such as decarbonization pledges, research and development, capital expenditure plans and the issuer's alignment to net-zero sector pathways, which give portfolio managers insight into both the financial materiality of investments and the external environmental impact.

BlackRock managed approximately $58 billion in sustainable fixed-income strategies as of Dec. 31.

Jon Hale, the Chicago-based director of sustainability research at Morningstar, said the ability to evaluate investments and apply ESG principles to fixed-income portfolios has significantly expanded over the past few years, as most asset managers now have access to more robust datasets.

"Our manager research team now asks each manager on their coverage list about their ESG capabilities. And virtually every asset manager, here or in Europe, can easily talk about and outline their ESG capabilities and the kinds of data they bring to bear, their philosophy, the way they approach ESG and sustainability issues," he said.

Mr. Hale said high-yield debt is an example of a space where investors can make more informed decisions now than they could a few years ago, as ESG coverage has expanded to include smaller issuers.

He said the coverage of smaller companies is more nuanced and that the ratings should not be done with the same template that would apply to a larger issuer, but ESG considerations can and should be applied to smaller companies.

"There's been this idea afoot for a while that because smaller companies are focused on making money and getting their business established, they don't care about ESG issues yet. And that thinking has started to change," he said.

Mr. Hale said size could also affect an asset owner's ability to meaningfully align their portfolio with ESG goals. He said it's an ongoing process for asset owners with large portfolios to align their fixed-income holdings with their ESG principles as the pool of available ESG data grows, but large asset owners generally have the resources and the investment infrastructure to meet their fiduciary responsibilities while also integrating more of their ESG principles into the portfolio. Mr. Hale said the gaps lie with smaller asset owners, such as smaller foundations and endowments, which have missions closely tied to environmental or social principles but rely on packaged investment solutions, such as ESG mutual funds, that are not tailored to their specific ESG priorities.

He said, "Many smaller asset owners, like community foundations, would be very highly interested in aligning their investments with their mission. If we're a community foundation in Oak Park (a Chicago suburb), why shouldn't we be aligning our investments with the values we're focused on in trying to make life better on the West Side of Chicago?"

Mr. Hale said pension plans are considering similar questions and evaluating their responsibility to participants in a broader social and environmental context. Rather than focusing more narrowly on the portfolio's investment risks, Mr. Hale said some plans are also asking: "Should we be investing in things that are contributing to future conditions in which our pensioners are not going to be able to enjoy their pensions, especially when it comes to climate change?"

Insurers also are considering sustainability factors in their portfolios, as "their state regulators are sending more and more signals that they should consider portfolio climate exposures," said Emily Lawrence, the Chicago-based North American director of sustainable investing client engagement for Northern Trust Asset Management.

"So, it's quite likely that will drive more interest across asset classes, particularly in sustainable munis," she added.

Ms. Lawrence said not all municipal bonds are aligned with equitable community intentions and outcomes, but they are instruments that finance a public purpose; for example, municipal bonds that align with initiatives in the United Nation's Sustainable Development Goals, such as bonds that fund investments in hospitals and community clinics or bonds that fund public education, have attracted ESG-tilted investments.

As of Dec. 31, NTAM managed $42 billion in U.S. municipal bond strategies.

"We see broad investor interest in aligning with the SDGs and municipal bonds are an asset class that can facilitate a clear connection to that framework," Ms. Lawrence said. "Individual investor interest in sustainable investing has grown significantly over the recent past, and we anticipate that intermediaries serving that segment through pension plans and wealth platforms will reflect that."

On the corporate bond side, integrating tools into an assessment model, such as the Sustainability Accounting Standards Board's Materiality Map, which provides investors with financially material sustainability information on corporate issuers, and the framework provided by the Task Force on Climate-related Financial Disclosures, allows portfolio managers to evaluate financially material sustainability information across a wider range of investment-grade and high-yield issuers, Ms. Lawrence said.

Ms. Lawrence sees more innovation coming to the ESG side of the corporate bond space and said: "It's exciting to see the growing interest institutional investors are showing in incorporating it into their fixed-income investments."