Every single asset owner in the world has a fairly similar portfolio. A large percentage of their assets are held in equities and bonds, usually with heavy domestic biases.
Yet in Asia at least, the concept of ESG has focused mainly on the equity side.
There are some good reasons for this. Factors such as environmental risk or employee rights are open-ended, and they are in part qualitative judgements on the priorities a company is taking in its corporate strategy. That makes them seem most appropriate for equity fund managers who can pressurise a company through annual general meeting votes than credit investors who cannot, and whose ultimate goal is being paid back.
“Bond investors often ignored ESG because they thought that it they don’t have votes through a proxy they can’t make a difference. But people can vote with their dollars and investors like us can be quite influential,” said the US head of fixed income at a major international fund house. The fund manager has incorporated ESG risks into its corporate in-house analysis of credits for several years.
Hermes is another manager with a firm devotion to ESG analysis. Mitch Reznick, its co-head of credit, noted that debt investors into long-term bonds have particularly good reasons to take ESG seriously.
“ESG integration respects that a number of financial factors play an important role in the trajectory of a company’s cashflows and therefore its enterprise value, and therefore its credit risk,” he told AsianInvestor. “We place that on equal footing in our investment decision with understanding and assessing a company’s operating and financial risk.”
It’s a potentially important issue, given that debt investments typically comprise a large percentage of Asian asset owner portfolios. Yet to date, the focus on ESG and fixed income has been mostly down to leading asset owners.
“At this point a lot of pension funds and some sovereign wealth funds are focusing on fixed income and ESG,” said Kevin Kwok, vice-president for ESG fixed income at index provider MSCI. “The asset manager side is lagging a bit … [they are] looking for signals that offer an opportunity in pricing.”
For asset owners and fund managers, the ultimate motivator to incorporate ESG is evidence that it can help identify companies at risk of credit defaults or restructurings.
That overlaps with, but is not identical to, the ESG motivations of equity investors.
“A lot of ESG information that’s sentiment-driven doesn’t have an impact on bonds or credit,” said Andrew Steel, head of sustainable finance at Fitch Ratings, adding that in emerging markets one particular factor stands out for credit investors above all others: “It’s all about G, then some concerns over E and it’s smaller on social.”
The best way to encourage more investors to adopt ESG factors in their debt portfolios is to supply evidence that doing so makes a positive difference.
Kwok at MSCI argues that it can. He noted that Swiss Re adopted some of MSCI’s credit ESG benchmarks in 2017, and after a year of investing against them revealed last year that it had maintained a minimum ESG threshold while witnessing 2% less downgrades and reducing its credit volatility and migration in its relevant portfolios.
He added that based on his own analysis, the G part of ESG is particularly relevant to bondholders and performance. “Broadly speaking the highest rated ESG-score companies typically had tighter credit spreads whereas those with the lowest scores had wider spreads and more volatility,” Kwok told AsianInvestor.
A major Asian asset owner has also been aiming to underline the positive potential offered by ESG in fixed income.
In April 2018 Japan’s Government Investment Pension Fund (GPIF) and the World Bank created a research programme to “explore practical solutions for integrating sustainability considerations into fixed income portfolios”.
Its initial report argued that ESG factors are “a material credit risk for fixed income investors” and considering them in credit research can improve credit risk analysis and ensure more stable financial returns.
However, the report also noted several challenges. One was that ESG data was not sufficient for sovereign bonds, asset-based securities and private debt. Plus it noted challenges over how debt investors could engage with issuers – especially governments, the role that ESG plays in credit ratings, and a lack of ESG fixed income indexes compared to equities.
The lack of benchmarks and definitive data helps explain why the ESG mandates of most Asian asset owner mandates have targeted equities, and they have focused the internal adoption of such principles on the stock parts of their portfolio.
The biggest exception has been Japan’s GPIF, co-creator of the fixed income ESG research programme. The ¥150.66 trillion ($1.3 trillion) asset owner has applied ESG criteria across all of its investments, including fixed income.
Outside of Japan, market experts say that regional asset owners are slowly increasing their engagement with ESG in fixed income investments.
“Since around 2016 to 2017 we have seen a change in quality and quantity of conversations we are having around ESG in Asia Pacific,” said Ilya Serov, associate managing director with Moody’s in Sydney.
“Asset owners are asking their fund managers lot of questions, and that reflects the policy environment in which we have been operating, on the back of the Paris Climate Agreement [in 2016].”
“I was recently in Korea and was surprised that institutional investors brought it [ESG in fixed income] up proactively,” added the fixed income head. “There’s been interest in Japan for a long time too, but it’s harder to identify exactly what’s going on in many other places; it’s a little behind Europe.”
A few other asset owners have engaged specific ESG fixed income mandates. Malaysia’s Kumpulan Wang Persaraan (Kwap) signed up to the United Nations Principles for Responsible Investing early last year and aims to ensure 70% of its portfolio is operating under ESG guidelines, including in fixed income, versus about 60% last year.
Most recently, the Asian Infrastructure Investment Bank (AIIB), a China-led multilateral agency, launched a $500 million Asia ESG Enhanced Credit Managed Portfolio in November. It invests into quasi-sovereign and corporate bonds related to ESG-friendly infrastructure projects.
Fund houses are beginning to engage more too, added MSCI’s Kwok. Asia Pacific accounts for 15% of the index provider’s overall ESG clients, up from 11% just two years ago, and Kwok noted the firm has been adding new clients in Australia, Hong Kong and Japan in particular, as well as China.
This story was adapted from a feature that focused on using ESG in fixed income investing in Asia, which was originally published in AsianInvestor's Spring 2019 edition.