Integrating ESG Considerations with Fixed Income


Christoph M. Klein, CFA

The traditional investment approach to fixed income links the credit risk of a security to financial metrics like profitability, leverage, and productivity. But modern responsible investing goes beyond that. It also integrates environmental, social, and governance (ESG) metrics for a more complete risk assessment.

For example, a traditional strategy may overlook issues such as carbon emissions. But if a company is in a high-emissions industry, it faces the risk of environmental regulations, which could increase its production costs and, in turn, affect its ability to service its debt.

The modern responsible approach to fixed income takes this risk into account and helps practitioners make better investment decisions. This was the main point made by Christoph M. Klein, CFA, a portfolio strategist, managing director, and head of ESG credit at Deutsche Asset & Wealth Management, during his presentation at the 68th CFA Institute Annual Conference in Frankfurt.

ESG Considerations Are Becoming Mainstream

Klein argued that interest in ESG issues in investment decisions is growing, fueled primarily by institutions. As of 2014, more than 1,200 institutions with $45 trillion had signed on to the Principles for Responsible Investment (PRI).

Klein believes that there has been a change in perception regarding fiduciary duty and ESG issues. In the past, considering ESG factors was seen as sacrificing performance in favor of sustainability and was therefore inconsistent with the fiduciary duties of institutional investors. But now, more institutional investors believe that it is a trustee’s fiduciary responsibility to include ESG in their decision-making and manager-selection processes.

Examples of Environmental, Social, and Governance Issues
Environmental Issues
Climate change
Energy resources and management
Biocapacity and ecosystem quality
Air/water/physical pollution
Renewable/nonrenewable natural resources
Social Issues
Employee relations
Human rights
Product responsibility
Health and safety
Consumer relations
Access to skilled labor
Governance Issues
Business integrity
Shareholder rights
Incentives structure
Audit practices
Board expertise
Fiduciary duty
Financial policy

Source: Principles for Responsible Investment (PRI)

Referring to a survey by Eurosif, Klein pointed out that while some may pursue responsible investing simply because of a “desire to be branded as responsible asset owners,” there are others who believe “that true fiduciary duty means considering all risks, including ESG [risks].”

ESG Brings “Sticky Money”

Klein noted that now almost every request for proposal (RfP) by pension funds and insurance companies includes detailed questions regarding internal ESG considerations in the investment process. Investment managers don’t win investment mandates because they are good at ESG, but they are likely to fail to win them if they are unable to meet the ESG requirements of the RfP.

Clients who care about ESG issues are “more sticky,” said Klein. They value the ESG-related work performed by investment managers and understand that ESG issues help performance over the long term. Klein said that one of his clients even had his ESG process audited. By being transparent with this client and letting the audit proceed, Klein strengthened the relationship. In the investment management business, you need a diverse set of clients with a long-term horizon, and ESG facilitates that.

BP Is a Case in Point

Klein said that poor management of ESG factors can be a contributing factor in corporate default, price volatility, credit rating downgrades, and widening credit default swap (CDS) spreads. He gave the example of BP. On 20 April 2010, the Deepwater Horizon oil-drilling platform exploded, killing 11 workers and resulting in a large oil spill, the results of which cost BP several billion dollars. Prior to the catastrophe, some of the ESG research on BP had shown that the company had significant safety and environmental violations at its US operations, including fines. For example, in March 2005, 15 people died and 180 were injured in an explosion at BP’s Texas City refinery, and in March 2006, there was a massive spill from a BP pipeline at Prudhoe Bay in Alaska.

Most investors were not paying attention to the concerns that some ESG research reports had raised. In 2010 as the news of the oil spill hit the market, the BP 5-year CDS spread jumped from under 100 bps to as high as 600 bps. It was then that the market participants started to pay attention to BP’s unenviable record on health and safety. It wasn’t just BP’s shareowners who were affected but also its creditors. Had the investors paid attention to ESG research, they could have taken a number of actions to manage the higher risk profile of BP, either by underweighting BP in their portfolios or by engaging with BP to improve its health and safety standards.

Focus on Relevance and Materiality

Klein emphasized that all ESG issues are not equally relevant and material across securities and other investments. Investors cannot be reasonably expected to analyze 200 key performance indicators for more than 5,000 companies. The relevance of ESG factors depends on various criteria, such as the specific sector, region, timescale, and leverage. For instance, the principal ESG factors for an energy company are going to be different from those of a technology company. Klein believes that ESG metrics may provide leading indicators for future risks, and buy-and-hold investors with a relatively longer term horizon are more exposed to future risks.

Klein believes that relatively large investment managers who can afford to buy ESG research from multiple providers can compare the findings and probe the differences to arrive at informed conclusions. Drawing on academic literature, Klein showed how ESG consideration can be included in a discriminant analysis to generate credit ratings.

Create Long-Term Performance and Benefit Stakeholders

Klein emphasized that through ESG integration and active engagement with issuers, investment managers can create long-term value and improve the lives of stakeholders without compromising financial performance. He gave the example of a mining company that set lower health and safety standards in its operations in a Commonwealth of Independent States (CIS) country compared to those in the United States. The bond holders saw the lower standards in the CIS state as a source of credit risk and engaged with the issuer to encourage it to improve them. When the issuer obliged, it not only lowered credit risk but also improved conditions for the mine workers. This is what Klein considers a real-life example of ESG research and active engagement reducing credit risk and benefiting stakeholders without sacrificing returns.

If you would like to know more about environmental, social, and governance (ESG) issues in sustainable, responsible, and impact (SRI) investing, please take the free eLearning course by CFA Institute: ESG-100: A Clear and Simple Introduction to ESG Issues in Sustainable, Responsible, and Impact (SRI) Investing.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

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