U.S. Demand Grows for ‘Safe ESG’ via Fixed-Income Vehicles

There is still not very much discussion in the U.S. about fixed-income investments pursuing ESG themes, according to BlueBay Asset Management’s My-Linh Ngo, but there are some compelling opportunities out there that institutional investors should consider.

RBC Global Asset Management recently published its third annual Responsible Investing Survey, and My-Linh Ngo, ESG investment specialist for the firm’s London-based BlueBay Asset Management division, offered PLANSPONSOR her take on the results.

At a high level, the survey results suggest institutional investors in the U.S. are rapidly warming to the utilization of environmental, social and governance (ESG) factors when building out their portfolios—and many are already implementing their own takes on ESG investing. Notably, the percentage of U.S. institutional investors that reject ESG considerations outright shrank dramatically year over year, from 51% to 34%.

Get more!  Sign up for PLANSPONSOR newsletters.

As Ngo pointed out, equities have long been the primary focus of ESG analysis and investing, but these days ESG analysis is quickly moving beyond equities. Thirty-percent of respondents in the U.S. said it is important to incorporate ESG into fixed-income considerations, Ngo said. Asked directly whether they incorporate ESG into fixed-income management, 52% of U.S. investors that already use ESG said yes.

“Our company has a core belief that ESG considerations are investment additives, not a hindrance to performance,” Ngo said. “Thinking about ESG helps us to generate a more holistic and informed view of how companies are performing, or are likely to perform in the future. So, we are applying an ESG risk overlay across all of the fixed-income assets we manage. It is not something that we limit to niche funds.”

Of course, the specific approaches BlueBay applies will vary across different products and geographies—but ESG risk overlays “come standard with every fund and investment product,” Ngo said. “We do it this way because we see ESG as something that can be quite beneficial in terms of measuring and addressing downside risk, especially on the fixed-income side.”

More Sophisticated Than Simple Screens  

According to Ngo, providers these days are taking a much more sophisticated approach to ESG than just running simplistic negative portfolio screens to avoid bad apples.

“Today we are conducting sophisticated analysis on the investment materiality of key ESG factors, and we are doing this in a rational way that looks across the entire institutional portfolio,” Ngo said. “I must stress, this work is not about running a bunch of negative screens, but instead it is about being scientific about how you build portfolios and truly acknowledging the risks you take.” It’s an unbiased, pragmatic approach that is grounded in focusing on the impact on investment performance.

Like other ESG advocates, Ngo said she was somewhat frustrated to see the most recent regulatory guidance issued in the U.S. on this topic—the Trump administration’s DOL Field Assistance Bulletin 2018-01. Ngo said this guidance is largely unhelpful and even potentially misleading, as it seems to discourage consideration of ESG factors by retirement plan sponsors while at the same time doing nothing to actually supersede the previous regulatory action, the Obama administration’s Interpretive Bulletin 2015-01, which encouraged more use of ESG. In the end, Ngo said, the demand for ESG is coming from investors themselves and is ultimately unlikely to be derailed by a lack of regulatory clarity.

Fixed-Income ESG Is Similar and Different 

Before taking a deep dive into the mechanics of ESG fixed income, Ngo first highlighted some of the ways that the analysis mirrors what is seen on the equity side of the portfolio.

“In absolute terms, both ESG equities and ESG fixed income are not quite mainstream yet,” Ngo said. “They are getting there, and in relative term, ESG thinking in equities is more mainstream. Another similarity is that both sides allow investors to come at ESG from both the business/economic perspective and from the values/beliefs perspective. We feel that, in both cases, ESG can benefit long-term risk-adjusted returns. Finally, both ESG equities and ESG fixed income still face similar issues in terms of inherent challenges of visibility and understanding in terms of the breadth and quality of the actionable data that is available.”

This point is echoed by recent Natixis research, showing 45% of institutional investors feel it is difficult to measure and understand financial versus non-financial performance considerations when establishing ESG programs. Some of their concern may be based on the criticism received by CalPERS and the New York City pension funds following fairly enthusiastic ESG implementation and fossil fuel divestment efforts. However, the Department of Labor (DOL) and other regulators and resources have offered extensive guidance on the topic as it pertains to retirement plans, it should be noted.

Moving on to the areas where ESG fixed income is different from equities, Ngo first pointed to the fact that on the equity side, generally speaking, investors can choose from a large universe of unique issuers, but at the same time the instruments they can invest in to get exposure to these companies are quite limited. Usually it is one share class or possibly two, Ngo said.

“What this means in practice is that you can take a very fundamental view on the equity side of whether you want to have investment exposure to a given company or not—because they only have that one vehicle and thus only one singular investment risk profile from the ESG perspective,” Ngo said. “This allows you to more easily build in your fundamental view directly into your decision of whether or not to invest in this company.”

On the fixed-income side, essentially the inverse is true.

“You have a smaller pool of unique issuers, but each of these has a larger pool of instruments you can invest in,” Ngo said. “What this means in practice is that each issuer will have a variety of different bonds that have different yields and different maturities. The different bonds will afford different levels of protection, as well, depending on the structure of the capital pool and how the bond is built. Thus, in practice, there are multiple credit risk profiles to consider for each issuer, depending on the bond that you choose to invest in. For this reason, the ESG analysis for fixed income is made that much more technical and quantitative.”

Another major difference to consider, Ngo said, is tied to the fact that equity markets “are so much more sentiment-driven relative to bonds, and they move at least in some degree according to what people are anticipating, with or without evidence, about the future.”

“In practice, this means a mere rumor can impact the share price of a company,” Ngo said. “Even if it is unsubstantiated, if there is a perception of risk this will be reflected in the stock price immediately, and potentially in quite a pronounced way. But when you look at fixed income, the credit rating is a more stabilizing force, in a way, because it is looking at the narrower but more extreme risk of the potential for default of that issuer. There are other risks in between, in terms of credit downgrades or upgrades, but it’s all much more tied to the real balance sheet of the company and how this relates to the maturity of your debt holdings.”

Based on these facts, Ngo said the determination of the materiality of ESG risks is more subtle on the fixed-income side, but also more ripe with possibilities.

“As an example, let’s say you have an energy company and it is very exposed to climate risks in the long-term, and let’s also say you have one short-term bond from the company and one long-term bond in your portfolio,” Ngo said. “Well, you can pretty easily argue that the ESG risk is less significant, potentially much less significant, for the short-dated bond, while the same risk is very material to the long-term bond.”

Stable Value Funds Expected to Prevail Despite Short-Term Interest Rates

While money market funds may look more appealing in the short run, this is not expected to last.

Since stable value funds invest in intermediate-term bonds and money market funds invest in short-term bonds, the recent rise in short-term interest rates has been creating some challenges for stable value funds, but experts say that condition is cyclical and that these funds should still hold great appeal for retirement plan sponsors and participants.

“Obviously, the interest rate environment over the past 12 months has been very challenging for stable value funds,” says Jonathan Kreider, vice president of investment products at Great-West Financial in Greenwood Village, Colorado. “There have been two headwinds. The increase in rates in the belly of the yield curve and the flattening of the curve is one, which is cyclical. The other challenge is structural. We are at a 10-year anniversary of the bull market in equities. All bull markets come to an end, and the cycle will dissipate.”

John Faustino, chief product and strategy officer at Fi360 in Chicago agrees that while the increase in short-term interest rates can make stable value funds a little bit less attractive than money market funds, this is usually a short-lived phenomenon. “It is true that rising short-term interest rates could create yields in money market funds that exceed those of stable value funds,” Faustino notes. “Over the past 50 to 60 years, there have been 10 times when the yield curve inverted, whereby three-month Treasury yields, more similar to money market durations, have been higher than five-year Treasuries, more similar to stable value duration.” However, what is important to note, he says, is that when those inversions did occur, they only persisted for five to six months.

“Since many stable value funds have provisions that require a plan sponsor to give 12 months’ notice before moving to a competitive product, it likely won’t make any sense for a plan sponsor to move,” Faustino says.

Kreider says it is also important to note that “if a change in interest rates occurs slowly over time, stable value funds’ crediting rates will be more responsive. There will be fewer losses in the underlying bonds, so the crediting rate is unlikely to decline. If the interest rate move is rapid, however, crediting rates might actually drop in the face of higher interest rates.”

Additionally, it is important to be aware of the fact that while stable value fund returns may for a time fall below those of products invested in short-term bonds, “there is always a lag for stable value funds to follow those returns,” but they always do.

Gary Ward, head of stable value at Prudential Retirement in Newark, New Jersey, says the recent market volatility should be a reminder to plan sponsors and participants of the critical role that stable value funds offer them. Since stable value funds offer steady returns with guaranteed principle, participants may want to include them in their portfolio, he says.

“In times of market volatility, it’s an opportune time for individuals to review their asset allocation, to ensure they have a diverse portfolio that aligns with their investment needs, and rebalance as necessary,” Ward says.

Additionally, with interest rates now rising, it is important to be aware that “stable value products are built to be responsive to rate increases without volatility in the returns,” Ward continues. “Stable value products are built for different market cycles and interest rate conditions, offer long-term benefits and are ideal for long-term savings vehicles like defined contribution plans.”

When considering a stable value fund, plan sponsors and advisers should conduct a thorough due diligence, Kreider says. This includes looking at “the credit rating of the issuer, the composition of the investment portfolio, the capital and reserves available to support guarantees, the historical crediting rates of the portfolio, termination provisions and any potential recordkeeping price reductions associated with the use of the product. Many clients will use a stable value fund that is offered by an investment manager affiliated with the recordkeeper. In these instances, we often see recordkeepers lower the overall, bundled price.”

«