Responsible investing has traditionally focused on equities, given shareholders’ ability to influence management decisions. But as responsible investing evolves, some global institutional investors are widening their focus to include fixed income.
Bondholders can also have far-reaching influence over governments and companies. Fixed income investors may seek to engage with debt issuers to better understand the environmental, social and governance risks they face, evaluate how they manage them and encourage them to improve their practices.
The centrality of fixed income is illustrated by the amount of global issuance, which is many times larger than the equity market. The role of these assets in investor portfolios, and their dominance across global markets, mean these assets cannot be ignored as investors seek to invest responsibly in pursuit of their goals.
Sustainability considerations form part of fundamental investment analysis, in addition to increasing explicit responsibility objectives. OMFIF’s 2020 Global Public Investor found that most of the central banks, sovereign funds and pension funds surveyed integrate ESG criteria into their investment programmes to seek superior risk-adjusted returns.
There are many examples of ESG risks having a material impact on the pricing of a bond, or leading issuers to default. The core focus for fixed income investors is the risk of an impairment to their coupons or return of principal. Any material risk that could affect whether an issuer fulfils these obligations – including ESG risks – will be relevant to investors’ analysis.
When it comes to engagement, headlines typically focus on the voting power of shareholders that enable them to influence and, if necessary, replace company executives. The reality, however, is that fixed income investors’ influence can far outstrip that of equity investors, primarily due to a range of institutions dependent on debt capital markets for financing.
Debt markets provide finance to a wide range of entities, including sovereigns, supranationals and agencies, as well as many companies, some of which prefer to raise finance using the debt rather than equity markets. This means that fixed income investors can influence entities and market sectors that are inaccessible to other investors.
While for major debt issuers, a single investor or asset manager can sometimes have little effect, collaborative initiatives can have meaningful impact. Fixed income markets can play a central role for investors seeking to influence governments and corporates.
When debt is issued, fixed income investors can influence the structure and terms of the issuance. A bond with unattractive terms could lead to financing on less favourable terms for an issuer. In rare cases, an issuer may withdraw an issue if there is not enough demand and sometimes change terms or documentation language to comply with investors’ requirements.
The regularity of debt issuance, combined with investors’ ability to influence the terms and structure, mean fixed income assets offer the potential for meaningful influence. Investors can target sustainability outcomes in a way that other asset classes – such as equities – cannot offer.
In the now mainstream use-of-proceeds bond market, issuance can be linked directly to specific projects with a positive environmental and/or social impact (the most common are green bonds, where bond proceeds are used to support environmental projects), or wider objectives – such as the UN Sustainable Development Goals. Some bonds also build in targets at the broader institutional level. If sustainability targets are met, the issuer benefits from more attractive financing terms. If targets are missed, the investor receives compensation for this failure.
The growth of the so-called ‘impact bond’ market means that debt issuers across a wide range of markets and sectors, including sovereigns and private companies, are being encouraged to pursue explicit sustainability objectives.
It also means that, through fixed income markets, investors are able to tailor their portfolios and objectives to reflect both financial and sustainability targets in new, innovative ways – more than other financial instruments. According to the GPI 2021, green bonds are the most popular and growing sustainable asset class, but there is not enough supply to meet the demand.
Investors are at the beginning of their journey to integrate a responsible investment approach into their fixed income portfolios. However, as investor practices evolve, the focus on ESG risks and sustainability factors could provide investors with further opportunities to build portfolios that can target both financial and sustainability targets with greater precision, creating better outcomes for all stakeholders.
Joshua Kendall is Head of Responsible Investment Research and Stewardship and Frances Barney is Head of Global Risk Solutions, BNY Mellon.