Perspective

US fixed income and ESG: which road should you take?


Asset managers across the globe are chasing their European peers to incorporate environmental, social and governance (ESG) factors into their investment processes. While the Europeans have a multi-decade head start, Stateside firms are closing the gap.

But what does integrating ESG into your investment process mean and how is it different from traditional fundamental investing? Is integrated the same as sustainable and impact investing?

This article will look at some of the different approaches to ESG investing and address these questions.

Fundamental versus integrated

Benjamin Graham is generally considered to be the godfather of fundamental investing. His groundbreaking book, Security Analysis, warned investors against speculation and urged them to analyse financial statements to estimate the value of an investment. Although this was in the context of stock market investing, it is equally relevant to corporate bond analysis.

Integrated research refers to incorporating non-traditional ESG factors into your investment process. Credit investors have always incorporated non-financial factors into their investment analysis. After all, the first “C” of credit investing is Character (alongside Capacity and Collateral) which is what we would describe as governance in an ESG context. Integrated research could be seen as an extension or another dimension of fundamental research. But what is different?

There are three key distinguishing characteristics of integrated research:

  1. Anecdote and conjecture are replaced with data science. Lots of data.
  2. Materiality is tailored to industries and markets.
  3. No moral or ethical judgements.

Better ESG data, reporting and improved technology offers the opportunity for more thorough analysis to compare and contrast ESG leaders and laggards. E, S and G inputs can be weighted according to their materiality and investment significance in each industry and market.

Most importantly, integrated research does not reduce or increase investments in certain issues, issuers, industries, or markets; it seeks to maximise returns by incorporating more information into investment decisions, including evaluating and taking account externalities or pre-financial cost and benefits.

This is no longer rare. Integrating ESG factor analysis with traditional fundamental research is becoming table stakes. A recent survey indicated that around 80% of credit investors use ESG integration either as their sole strategy or combined with one or more other strategies.

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There is a spectrum of approaches to ESG investing, according to investor priorities. This runs from taking ESG factors into consideration (Integrated) to promoting ESG characteristics (Sustainable) to trying to achieve positive sustainability outcomes alongside returns (Impact), to “doing good”, where return is not the primary motivation (Philanthropy).

Given its historical focus, it is not surprising that Europe has been among the first to try to establish a common ESG classification framework. The US, by comparison, is still in the “request for comment” stage.

With the global rush to label funds as “Sustainable” or “Impact” regulators are trying to establish minimum disclosure standards, mainly to prevent “greenwashing” (where an organisation lays claims to ESG credentials, which it doesn’t live up to in practice).

From here in the US, we have observed with interest the ESG fund classification framework in the European Union, emerging from the Sustainability Financial Disclosure Regulation (SFDR).

The SFDR has one purpose; if you claim to be sustainable, tell us what you are doing and how. There are three classifications, Article 6, 8 and 9. Article 9 is for funds with sustainability objectives that “contribute”. Article 8 for funds that “promote” environmental or social objectives and Article 6 covers funds which integrate ESG factors with traditional fundamental research. If they don’t think these factors are relevant, they must explain why not. Each asset manager must decide what contributing (Article 8) or promoting (Article 9) environmental or social objectives means for their investments and disclose accordingly.

Even though there is an emerging consensus in the US regarding what is Integrated investing, there are no standards or even disclosure guidance for Sustainable or Impact funds. While the SEC is very focused on creating standards, firms have started offering Sustainable and Impact funds with bespoke definitions and disclosures.

Sustainable or Impact investment performance is always a burning question and it remains difficult to assess. Standard analysis assumes a focus on contributing or promoting environmental or social objectives reduces the investable universe,  hampering the portfolio construction process or even lowering returns. Especially given that most green bonds trade at a premium or “greenium”.

ESG factors are relevant inputs to investment decisions, and currently the opportunity loss is minimal as credit market spreads are tight. We also expect a favorable ESG technical effect to become increasingly evident over the next few years, as more and more capital is invested on the basis of ESG integration, compounded by growing client demand for ESG products.

We cannot quantify the return costs or benefits of sustainable or impact funds, we can only say that we expect returns will be different than basic fundamental or integrated funds.

What should best practice look like?

As we wait for US guidance and standards to develop, we believe sustainable or impact titled funds could take the SFDR as a guide. In our view, a sustainable fund should have a better externality score than its benchmark, based on assessments and ratings of companies on ESG factors or metrics. Given the inconsistencies of third party ESG assessments and ratings, proprietary tools, assessments and scores are essential.

Sustainable investing could, and likely should, also focus on best in class companies that score well from an ESG perspective and respond favourably to engagements on improving disclosures and adopting improved policies. Environmentally destructive, socially costly, and human rights violators should be avoided as they often are avoided in other portfolios. There should be opportunities to invest in laggards if they demonstrate improving sustainability paths relative to peers.

The threshold for impact investing is higher than for a sustainable fund. Arguably, to use the SFDR term for Article 9 funds, most of Impact fund investments should “promote” the United Nations Sustainable Development Goals.

These funds should only invest in companies that do not cause significant environmental or social harm while also having good governance practices. Like Sustainable funds, Impact funds should require independent ESG assessments and scoring, active engagements and positive externality scores.

The future of credit investing

Asset owners want the best risk-adjusted returns. Integrating ESG factors with traditional fundamental research is key to understanding longer term pre-financial costs and benefits.

Sustainable funds offer asset owners the added opportunity to contribute to improving social and environmental factors while minimising uncompensated ESG risks. Impact funds promote the reduction of future environmental and social costs through positive inclusion of sustainable themes.

Transparent reporting is key for both Sustainable and Impact strategies. As ESG credit investing becomes more pervasive, unrealised external costs and benefits will materialise and impact the financial statements and credit spreads.

Welcome to the future of credit investing.

[1] https://www.sec.gov/sec-response-climate-and-esg-risks-and-opportunities

[2] https://sdgs.un.org/goals