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ESG in debt vs equities: commonalities and differences


Sustainability focused investing has been gathering pace over the last decade, with equity funds attracting a lion’s share of interest from investors focused on ESG.  According to IMF data as of mid-June last year, fixed income strategies account for less than one-fifth of the assets under management.  Yet, the bond market is almost double the size of the equity market.

A number of reasons can explain this development.  The ability to vote shares, a clear link to corporate engagement, more comprehensive ESG research, and various benchmarks and indexes have been the critical factors behind the dominance of ESG in equities.  For example, the first ESG equity index was launched in 1990, while the first fixed income ESG index was brought to the market in 2013.

  • On the other hand, the diversity of different debt instruments and the complexity related to their pricing, including issues such as payments schedule, optionality, currency, etc. have posed greater challenges for incorporating ESG factors in debt securities.

    The reality is that most of the financially material ESG factors that an equity investor would consider apply to a fixed income analysis as well.  In general, you would expect companies with less exposure to environmental risks to rate well on the “E” factor from both an equity and fixed income perspective.  The same is true for social and governance scores.

    Yet, there are a number of differences in the ESG application between bonds and equities that are important to highlight.

    Firstly, ownership of equities gives investors voting rights and the ability to voice their views on ESG related issues at annual shareholders meetings. Bondholders are lenders who determine credit terms for an issuing entity.  While voting isn’t an option, as bonds mature and issuers come to the market for new debt or to refinance their existing debt, bond investors have the opportunity to engage and influence a company’s behaviour.  Hence, engagement with companies is implicit rather than explicit as is the case with equities.

    Secondly, unlike equities that offer unlimited upside potential, bonds have an asymmetric risk profile with known ultimate value.  Hence, ESG analysis is considered mainly as part of downside risk mitigation with the focus on repayment and default risk.  Further, ESG analysis in debt instruments is usually two-pronged:  it considers the “use of proceeds”, i.e., the type of project the proceeds of a particular bond’s issuance are assigned for, as well as the sustainability of the issuer/company itself.  The “use of proceeds” consideration, in particular, gives a bond investor some scope to direct the proceeds of that bond towards an impactful project.

    Another interesting difference between bonds and equities from an ESG perspective relates to the flexibility of a bond investor to express their views about the same issuer/company by choosing bonds of different durations and/or seniority.  This is not an option for an equity holder who either holds a company stock or not.

    ESG equity strategies are likely to continue to lead in the popularity stakes; however, demand for ESG fixed income strategies is expected to quickly catch up.  The main drivers are:

    • Investors across the board are becoming increasingly focused on understanding the impact of non-financial factors of their overall portfolios, beyond equities.
    • The industry increasingly recognises that ESG issues can present material credit risk and that ESG integration is improving the ability of fixed income investors to better price the risk of bonds over the long term.
    • Rating agencies such as S&P and Moody’s have been integrating sustainability into their ratings framework for the last few years and have been reporting on bond issuers’ ESG risks in a way that impacts their cost of capital.
    • Advances in ESG fixed income indexing and the continued diversification of the market in terms of both issuers and funds have provided a range of investment solutions to a variety of investors.
    • Impact investing in the bond market continues to evolve. This category includes “green bonds” (promoting climate or other environmental sustainable purposes), social bonds (supporting social programs) and sustainable bonds (financing projects with broader mandates and the ones linked to the UN Social Development Goals). Blue bonds are the most recent member of the impact investing family with the proceeds aimed at financing marine and ocean-based projects with positive environmental and economic benefits.
    • Importantly, the research suggests it is achievable to create fixed income portfolios that offer a significant improvement in key sustainability metrics such as a reduction in carbon intensity without significantly deviating from duration and yield of standard bond indexes.

    To conclude, for clients seriously interested in responsible/sustainable investing it is difficult to overlook fixed income securities.  ESG focused bonds, and more specifically sustainable bonds can provide the same returns and diversification benefits to equities as traditional fixed bonds while having a positive societal and environmental impact.

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