There is a perception that being an ESG investor is becoming incompatible with being an income investor. We don’t think that’s true.
Finding decent income and maintaining a clear conscience is a growing challenge for investors.
The reason is fairly straightforward: investors don’t want to invest in companies and countries that they perceive to be causing harm. It’s an ethical stance, but it’s also because those investors are questioning the prospects of certain industries.
Energy and tobacco companies, for example, offer some of the highest yields on the market. Utility companies do too, and they are some of the biggest users of fossil fuels.
This has created a perception to some extent that being an ESG investor (focused on environmental, social and governance issues) is becoming incompatible with being an income investor. We don’t think that’s true.
We believe there are three ways that income investors can make sure that their income is sustainable.
On the face of it, the equity sectors with the highest dividend yields tend to have lower sustainability scores, while those sectors with the lowest dividend yields have somewhat higher sustainability scores (Figure 1).
By ‘sustainability score’, we mean the score generated by our proprietary tool, SustainEx. It analyses and quantifies the impact that companies in the sector have on their stakeholders and the planet, going beyond companies’ financial statements and capturing both positive and negative externalities.
Utility companies, for example, are often able to pay high dividends due to having regulated assets, restricted competition and the ability to raise prices with more certainty than some other sectors.
Consumer staples, meanwhile, have a consistent stream of earnings insensitive to changes in consumer tastes or fluctuations in the broader economy. However, both sectors score badly on sustainability measures – utilities for their propagation and use of non-renewable energy, and consumer staples for their profiting from habitual or addictive products like alcohol and tobacco, and the resulting impact on consumer health.
Those headline numbers mask differences between companies under the surface.
Looking at those two sector examples again, Figure 2 shows that there are many companies with high yields and sustainability scores at or above zero, which means they are unlikely to have a significant negative impact on society. Indeed many utilities companies have a net positive impact on society, and many of them have high yields. The trick, then, is to be selective within sectors as well as between.
2. Take a multi-asset approach
A multi-asset approach enables investors to diversify their income sources.
At the time of writing, it is possible to earn an attractive yield across the credit spectrum, emerging market bonds and in alternative assets like preferred shares, insurance-linked securities (ILS) and property (Figure 3). These assets have a different risk profile to traditional income assets like high yielding equities and government bonds. Diversification also allows investors to introduce strategies that target a better sustainable outcome, for example thematic investments like renewable energy equities or green bonds.
But it is not only a case of diversifying between asset classes; investors also need to think about the opportunities available to generate income within asset classes.
Looking at this another way, investors typically have to take on more risk in order to generate higher yields. That’s because higher yields compensate investors for higher risk. Investors can position portfolios in portions of the market with both higher income and stronger sustainability scores by combining established risk measures with new sustainable approaches that account for risk.
A multi-asset approach also allows for a broader range of ways by which a portfolio can exhibit sustainable characteristics. We’ve talked about equities, and the same applies to credit, whereby investors lend to companies instead of buying their stock. Ultimately, those companies which have a net negative impact on society or the environment will be considered to be less sustainable than those which have a net positive impact.
It gets more difficult with lending to governments, where judgement about sustainability is more subjective, but we have tools that we can use to rank countries on their sustainability characteristics. For example, we use a tool that we call the ‘country sustainability dashboard’, which gives us a first reference about where countries sit on the sustainability scale. We compare sustainability scores to bond yields for a selection of countries in Figure 4.
Sustainable investing, however, is more than just the provision and withdrawal of capital. Within equities, sustainability is better pursued through active ownership – engaging with company management for change – than through divestment.
Within credit, investors lend money to a company for the management to use in sustainable projects, or withdraw the lending if they fail to prove that they’re doing so.
Engaging with governments or impacting their capital base is more difficult, but collective action on the part of many investors is still possible. In any case, government bonds are often used as risk management tools rather than core income generation tools; Figure 3 showed the relatively low yields on offer.
A dynamic approach allows investors to protect a portfolio against valuation risk and take advantage of valuation opportunities, while also navigating the risks and opportunities that arise from business cycle uncertainty.
Starting yields are not always a good measure of future returns. In fact, a high starting yield can reflect greater risk associated with the investment (see Figure 5).
It is therefore important to keep an eye on metrics such as payout ratios and dividend coverage (for equities) and interest coverage and EBITDA/debt ratios (for credit). Furthermore, given that SustainEx is forward-looking, it can help to assess the resilience of dividends.
A dynamic approach allows investors to shift away from value traps where future dividends or coupons are at risk and into the areas where attractive yields are backed by strong fundamentals.
In addition to valuation risk, income strategies are exposed to changes in the economic cycle. Equities and corporate bonds are cyclical in nature and high income segments are exposed to dividend cuts and corporate defaults. A dynamic approach allows investors to navigate the economic cycle by shifting from cyclical into defensive strategies during the slowdown or recession phase and vice versa during the recovery and expansion phase of the cycle (see Figure 6).
Dynamism is valuable with respect to sustainability, too. Sector sustainability rankings stay fairly consistent most of the time, with healthcare and consumer staples comfortably the best and worst (see Figure 7).
But that’s not to say that sectors can’t change their sustainability spots. Notably, some industries and sectors transition and subsequently affect others. For example, the continued development of renewable energy, which has utility-like returns, could impact the cash flows of oil and gas.
We believe it is possible to build a portfolio of sustainable income by:
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