Responsible Investing Is Smart Investing in the Debt Capital Markets

Fiona Reynolds, Principles for Responsible Investment

18 September 2014
Although responsible investing in fixed income is relatively new for most investors, integrating
environmental, social and governance (ESG) analysis into investment decisions can help asset
owners better identify and manage credit risk.
Responsible investment (RI), an investment strategy that seeks to generate both financial and sustainable
value, continues to gain ground across the financial services sector and is now actively being used across
different asset classes. A new report from the Principles for Responsible Investment (PRI)
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has looked at the
use of RI in fixed income, the first study to look at this asset class.
The euro zone crisis highlighted the need for investors to rethink the way they analyze creditworthiness. One
way is to integrate environmental, social and governance (ESG) analysis into investment decisions.Although
RI in fixed income is relatively new for most investors, the integration of ESG factors in mainstream fixed
income investment works well because of the common focus on producing stable incomes to meet liabilities
over the medium and long term.
Overall, we are seeing much greater awareness of how ESG factors can manifest themselves into material risks
that undermine creditworthiness and that by incorporating ESG into fixed income, asset owners can help to
identify and manage credit risk.
Overcoming Barriers to ESG in Fixed Income
Fixed income investors can look to lessons learned in private equity, where RI has been successfully
incorporated by firms such as Blue Wolf Capital Management, Doughty Hanson, KKR and Permira. Some of
the challenges within fixed income include bondholders being relatively unfamiliar with engaging issuers on
ESG matters; a lack of consensus on which ESG indicators give the most insights; the absence of ESG
research coverage for high-yield, emerging market and non-listed issuers; and fixed income performance
perceived as less sensitive to ESG factors than other asset classes.
But the benefits are numerous with regard to using ESG criteria to make investment decisions, including better
risk analysis and valuations. This is applicable for corporate bond investors; sovereign, local government and
supranational issuers;and financial sector issuers and asset-backed securities issuers.
[Related: A New Era for Buy-Side Risk Analytics (QuantFORUM)]
As with all asset classes, RI in fixed income is primarily about maximising financial value by managing risks,
uncovering opportunities and constructing portfolios that are aligned with the values of clients and
beneficiaries. But, for RI to be effectively embedded within an organization, training and support need to be
provided in order to fully understand the complex relationships between ESG and investment performance.
This includes encouraging ESG experts to work with fixed income analysts to understand the issues involved
and develop thematic research, and encouraging analysts to seek insights from ESG research teams.
Issues remain around how best to use ESG in fixed income, which the financial services sector will no doubt
continue to avidly discuss. But for now, our research shows that when RI is presented as a tool for analyzing
risks and gaining a competitive edge, there is rapid buy-in from staff and myriad benefits to investors.
The Rise and Rise of Themed Investments
One of the indicators for increased use of ESG in fixed income is the growing demand on the part of investors
for environmental and social themed investment: products that deliver attractive returns and more sustainable
outcomes and that focus specifically on sustainability for example, clean energy, green technology or
sustainable agriculture. These can include green bonds, social impact bonds or charity bonds.
In particular, the green bond market has been growing rapidly and is seen by many as a way of addressing ESG
risks such as climate change and water scarcity. Bloomberg noted in June of this year that a record $16.6
billion of green bonds have been issued to date in 2014, driven by a surge in corporate self-labelled issuance
and sustained volumes from large international and supranational banks. At its current pace, total 2014 volume
could surpass $40 billion, triple the $14 billion issued in 2013.
Themed products offer considerable potential for investor returns, while also addressing important
sustainability issues. However, the themed bond market needs to adopt standards in order to protect the
interests of investors and ensure continued growth of the market. Few investors agree on definitions of
green, and invariably, investors will need to decide on what shades of green they want to invest in. In
addition, few if any issuers will comprehensively audit the additionality or impact of their green investments.
And because there is not clear consensus on the definition of green, investors also need to ask themselves
how green they want to be; for example, do carbon capture and storage (CCS) or fracking count as green? But
themed bonds can be a useful tool for asset liability management. For example, tighter regulations on carbon
outputs may result in a significant decline in demand for coal, and green bonds offer an opportunity to
transition away from such sectors.
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- The PRI Fixed Income Investor Guide sourced content from desk research, interviews with prominent fixed
income investors, the PRIs Fixed Income Implementation Working Group and information disclosed in PRIs
Reporting Framework. It is part of an ongoing stream of work to promote responsible investment (RI) in this
asset class. Participants included KfW Bankengruppe, Union Investment, BlueBay Asset Management,
Neuberger Berman, Deutsche Asset & Wealth Management, Zurich Insurance Group and Calvert Investments.
The report explores a range of issuer types, such as governments, corporations and financial institutions, and
touches on different (listed and private) instruments, including asset-backed securities.

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