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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, integratingenvironmental, social and governance (ESG) analysis into investment decisions can help assetowners better identify and manage credit risk.

Responsible investment (RI), an investment strategy that seeks to generate both financial and sustainablevalue, continues to gain ground across the financial services sector and is now actively being used acrossdifferent asset classes. A new report from the Principles for Responsible Investment (PRI)

1has looked at the

use of RI in fixed income, the firststudy to look at this asset class.

The euro zone crisis highlighted the need for investors to rethink the way they analyze creditworthiness. Oneway 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 fixedincome investment works well because of the common focus on producing stable incomes to meet liabilitiesover the medium and long term.

Overall, we are seeing much greater awareness of how ESG factors can manifest themselves into material risksthat undermine creditworthiness and that by incorporating ESG into fixed income, asset owners can help toidentify 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 ofthe challenges within fixed income include bondholders being relatively unfamiliar with engaging issuers onESG matters; a lack of consensus on which ESG indicators give the most insights; the absence of ESGresearch coverage for high-yield, emerging market and non-listed issuers; and fixed income performanceperceived 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 betterrisk analysis and valuations. This is applicable for corporate bond investors; sovereign, local government andsupranational 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 beprovided 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 involvedand develop thematic research, and encouraging analysts to seek insights from ESG research teams.

http://www.unpri.org/viewer/?file=wp-content/uploads/PRI-fixed-income-investor-guide-2014.pdfhttp://tabbforum.com/microsites/quantforum/articles/a-new-era-for-buy-side-risk-analyticshttp://tabbforum.com/microsites/quantforum/articles/a-new-era-for-buy-side-risk-analyticshttp://tabbforum.com/microsites/quantforum/articles/a-new-era-for-buy-side-risk-analyticshttp://tabbforum.com/microsites/quantforum/articles/a-new-era-for-buy-side-risk-analyticshttp://www.unpri.org/viewer/?file=wp-content/uploads/PRI-fixed-income-investor-guide-2014.pdf

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Issues remain around how best to use ESG in fixed income, which the financial services sector will no doubtcontinue to avidly discuss. But for now, our research shows that when RI is presented as a tool for analyzingrisks 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 investorsfor environmental and social themed investment: products that deliver attractive returns and more sustainableoutcomes and that focus specifically on sustainabilityfor example, clean energy, green technology orsustainable 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 ESGrisks 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 issuanceand sustained volumes from large international and supranational banks. At its current pace, total 2014 volumecould surpass $40 billion, triple the $14 billion issued in 2013.

Themed products offer considerable potential for investor returns, while also addressing importantsustainability issues. However, the themed bond market needs to adopt standards in order to protect theinterests of investors and ensure continued growth of the market. Few investors agree on definitions ofgreen, and invariably, investors will need to decide on what shades of green they want to invest in. Inaddition, 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? Butthemed bonds can be a useful tool for asset liability management. For example, tighter regulations on carbonoutputs may result in a significant decline in demand for coal, and green bonds offer an opportunity totransition away from such sectors.

1- 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 PRIsReporting Framework. It is part of an ongoing stream of work to promote responsible investment (RI) in thisasset 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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