ESG Investing Has Extended to Fixed Income

While interest in investing in environmental, social and governance (ESG) factors through equities has been gaining steam, so too has interest in applying ESG factors to the fixed income portion of portfolios.

“We have seen strong adoption of ESG in equities in the past few years, and that has now extended to fixed income,” says Hitendra Varsani, executive director of MSCI Research. “Only in the past few years has the demand for ESG fixed income opportunities accelerated.”

MSCI Research seeks out ESG fixed income and equity opportunities not by looking at a particular security—be it a bond or a stock—but by screening issuers for 37 key factors that MSCI Research has determined identify true commitment to ESG, Varsani says. This research is conducted by more than 200 analysts at the firm.

The 37 key issues are mostly centered on risk factors to rate each issuer on their ESG effectiveness, he says. “From there, we use the research to conduct various analytics, indexes and additional research,” Varsani says. “In the past, ESG was viewed from an impact or values-based perspective. Today, however, investors now recognize ESG as having material impact on performance, which is why many are adopting ESG across their entire portfolio. ESG screens can lead to better financial characteristics and fundamentals, like cash flow, volatility and risk exposure.”

He adds that fixed income portfolios have historically been organized by duration and credit quality. ESG, Varsani says, provides another dimension of financial assessments beyond the balance sheet and cash flow metrics to reveal issues that can impact the successful running of the business and risk mitigation. “That can lead to better outcomes for investors. Being less exposed to market downturns improves risk-adjusted returns. For ESG fixed income investments, it is less about the upside and more about risk mitigation,” he says.

Brian Woolfolk, head of the institutional division at Pacific Life, says the company has just introduced a sustainable bond framework, under which it can issue sustainable bonds through the capital markets group of its institutional division.

One key element of the sustainable bond framework is a commitment to investing an amount equal to the net proceeds of the issuance of sustainable bonds in one or more of the following projects: green buildings, renewable energy and energy efficiency, sustainable water and wastewater management, terrestrial and aquatic biodiversity, clean transportation, and access to essential services such as education and affordable housing.

Like Varsani, Woolfolk says applying ESG screens to fixed income investments can lead to “superior risk-adjusted investments that provide scalable and value-added solutions to our clients.”

David Norris, head of U.S. credit at TwentyFour Asset Management, cautions that while some issuers of ESG stocks have made information on their criteria available to the market, information on ESG fixed income opportunities is not as prevalent. “The biggest issue for potential investors in these funds, particularly in the U.S., is finding the information on their ESG criteria,” Norris says.

Bradford Cornell, emeritus professor of finance at the Anderson School of Management at UCLA, maintains that green bonds are more expensive than regular bonds. There aren’t that many green bonds on the market, he says, probably because if a green company wants to fund an ESG-friendly project, such as a wind farm, it can simply issue a regular bond at a lower interest rate. “The only reason it might issue it as a green bond is marketing,” Cornell says.

He says he believes ESG investing, be it in equities or bonds, is a passing fad. “As it stands now, some ESG investments include Apple, Google and Facebook,” Cornell says. “These is some dispute as to how these funds are getting away with this, and the SEC [Securities and Exchange Commission] is starting to look into this, particularly because ESG funds typically have added fees due to their additional screening. I tell investors to be careful about ESG fixed income investing. If the issuer is getting the benefit from the strategy, it is coming out of the pocket of the investor.”