Bondholders Begin to Flex Their Muscles

Upscaled climate engagement in fixed income is the next frontier for sustainability-focused investors. 

As the climate crisis has worsened, pressure on publicly-listed companies to make net zero commitments and transition to low-carbon operations and products has intensified. Asset owners have used their leverage as shareholders to accelerate the pace of change. But reaching net zero by 2050 is a global effort that requires investors to set short- and long-term decarbonisation targets across every asset class they invest in, including fixed income. 

“Fixed income assets are a critical part of [the climate engagement] equation: the size of the debt market eclipses that of the public equity market, and companies are constantly seeking capital from fixed income investors through the issuance and reissuance cycle,” says Stephanie Pfeifer, CEO of the Institutional Investors Group on Climate Change (IIGCC). 

The fixed income market totals around US$130 trillion in outstanding debt, compared to US$42 trillion in global equities, suggesting that climate-focused stewardship from fixed income investors could massively contribute to the global net zero transition.  

So far, they have thrown their support behind the burgeoning green bond market, where transparency and targets offer reassurance of positive impact, engaging less frequently with existing holdings. Increasing demand for sustainable products from bondholders prompted total issuance of green bonds to surpass US$2 trillion in September, according to the Climate Bonds initiative.  

“The emergence of the sustainable finance or ESG-labelled issuance market in recent years is an exciting development which makes it possible for debt investors to proactively channel capital to more sustainable activities and provides a basis for targeted engagement,” adds My-Linh Ngo, Head of ESG Investment at BlueBay Asset Management. 

Investors do engage with long-term bond-holdings on climate risks, but it’s currently targeted at key sectors.  

“Fixed income is important because many high-emitting sectors, such as energy utilities, are highly leveraged and raising debt capital is a key way of financing their activities,” says Simonetta Spavieri, Senior Engagement Analyst at Royal London Asset Management (RLAM), noting that bondholder influence is therefore “essential” to influence these sectors.  

The influence of sustainability-minded investors can be seen in divestment strategies of both state- and privately-owned debt issuers. “Many high-emitting miners and oil and gas companies are pushing their fossil fuel assets to private markets,” says Spavieri. 

Overall, however, experts acknowledge that the full weight of bondholders has yet to be felt, in terms of climate- and other environment-related engagement. UK water utilities have even asked bondholders to speak up more as the industry struggles to address its infrastructure investment challenges.  

“Bondholders certainly have a seat at the table, but they have their say differently from equity holders,” says Yo Takatsuki, Global Head of Investment Stewardship at JP Morgan Asset Management. 

Increasing collaboration and new guidance may soon result in the bondholder’s voice being heard more frequently.  

Changing perceptions 

In 2022, climate engagement is integral to the portfolio emissions reduction strategies of asset owners. Having set overarching climate-related targets for their portfolios (science-led and aligned with a 1.5°C temperature pathway), they engage with investee firms that are not yet net zero-aligned to discuss the steps needed to decarbonise their operations. 

If investee companies are falling behind or failing to set suitably ambitious targets, public equity investors can raise their concerns privately or publicly, individually or collaboratively, perhaps escalating via an annual general meeting (AGM). Divestment is typically a last resort. 

“Investors in public equity are owners of a company, and by extension a company’s emissions, so it’s natural that equity investors have adopted an earlier focus on engagement for climate action,” says Jonathan Davis, Client Portfolio Manager of Global Emerging Markets Fixed Income at PineBridge Investments. 

Even though bondholders can’t vote at AGMs, an absence of regular voting rights “doesn’t mean an absence of influence”, points out IIGCC’s Pfeifer. 

“As lenders, we can and do have influence, it’s just different in its dynamics to equity investors,” agrees BlueBay’s Ngo. “Ultimately, companies would generally prefer to engage in debt financing rather than give up equity, and for sovereigns there is no option of the equity market for them.” 

At first glance, collaborative investor-led engagement initiatives like Climate Action 100+ (CA100+), seem to be predominantly focused on public equity, targeting over 100 of the highest emitting global companies to ensure they have set ambitious net zero targets and are actively reducing their emissions.  

But several focus companies are also bond issuers, such as multi-energy company TotalEnergies. Following engagement efforts led by Federated Hermes and BNP Paribas Asset Management, in 2020 Total committed to achieving net zero across Scopes 1-3 emissions by 2050 or sooner. Both Federated Hermes and BNP Paribas are also fixed income investors.  

RLAM is co-lead in CA100+ engagements with energy utilities E.ON and EDF. “Our exposure to both companies is mostly through bondholding,” says Spavieri. 

CA100+ has included corporate bondholders for a long time, says Takatsuki, noting that “it’s more of a perception issue that this isn’t [seen to be] the case”. 

“Insurers, for example, are predominantly corporate bond investors – so when they talk about their engagement efforts, they are largely talking through the lens of bondholder engagement,” he adds. 

Distinct challenges 

Climate-related engagement in the fixed income market involves a number of distinct challenges, relating to the nature and needs of both issuers and investors.  

In particular, it gets a bit trickier for bondholders to engage on climate-related issues with sovereigns, requiring “sensitivity to cultural dynamics and avoiding infringing on sovereignty”, says BlueBay’s Ngo, adding that these conversations are especially difficult if the government in question has a high economic dependency on fossil fuels. 

On both sides of the fence, the channels and processes for dialogue are less well established in the sovereign debt markets, but this is beginning to change, with governments and investors engaging as part of the development of their green bond issuance frameworks.  

Perhaps more so than equity shareholders, the degree of influence a bondholder has over a company also fluctuates in line with the issuance cycle. Asset owners are typically ‘buy-and-hold’ investors in a large but not necessarily liquid fixed income market. This means their influence can be substantial, but mainly at specific times of need.  

“Debt investors will have more scope to affect issuer priorities and behaviour when issuers are issuing new debt (primary issuances) and less when the bond is being traded in the secondary market, although their ability to influence increases again in the case of restructuring if the issuer is to avoid defaulting,” says Ngo. 

Ultimately, the interests of bondholders and equity holders are aligned, “because they all want sustainable growth and strong financial returns”, says Takatsuki. 

Engagement in action 

RLAM reached out to investee companies contributing to 50% of its financed emissions in 2022 and provided them with the firm’s expectations for credible climate transition plans. It rated these companies across 12 indicators spanning three categories: setting 1.5°C-aligned net zero targets, bringing along the wider economy to net zero, and demonstrating immediate climate action. 

Spavieri says that the majority of these targeted companies are held in both equity and fixed income, “but a few we have met this year are purely held in our fixed income portfolios”. 

“For example, oil and gas companies we met, such as Tullow Oil or Kosmos Energy, are only held in our high yield funds,” Spavieri says. 

According to RLAM’s 2021 stewardship report, 12.5% of its engagements targeted fixed income, compared to 68.3% equity, and 19.3% both equity and fixed income. 

BlueBay is engaging with both corporate and sovereign issuers on climate-related issues, says Ngo. “The focus can range from seeking disclosures on their exposure to climate risks, as well as the quality of their mitigation and adaptation strategies, to encouraging adoption of goals and targets.” 

The firm is also engaging with corporates and governments in relation to deforestation, raising concerns both with food producers and governments, as part of the Investor Policy Dialogue on Deforestation (IPDD).   

Takatsuki says green bond issuance has supported a “growing climate-focused engagement dynamic” between investors and sovereign bond issuers.  

“Investors are now able to have a more active dialogue with governments about the climate risks, calling for transparency and clearer policy direction. While nascent, the ability for bondholders to start having these kinds of conversations more frequently and proactively is a huge positive,” he adds.  

More needs to be done to upscale engagement efforts with the sovereigns, sub-sovereigns and state-owned entities which control an overwhelming share of fossil fuel reserves, admits Ngo.  

“Investors need to be asking more questions more routinely of high-carbon impact issuers about their climate strategy when they come to the market to raise new capital, irrespective of whether it is a regular or an ESG-labelled bond, as that is the point of maximum influence,” she says. “We also need to see more consequences of poor or inadequate climate practice when it comes to an issuer’s ability to access markets, and the cost of doing so.” 

Building momentum 

The Investment Association (IA) recently published guidance for members on stewarding fixed income assets to ensure more integration across debt and equity holdings, following a 2020 report  by HM Treasury’s Asset Management Taskforce.  

According to the IA, drivers of enhanced fixed income stewardship include the financial materiality of sustainability considerations to asset valuation, capital structures of companies increasingly consisting of large amounts of debt, and “institutional investors increasingly seeking positive non-financial outcomes from their investments and seeking exposure to debt instruments that support their sustainability goals”.  

One of its recommendations is for bondholders to engage on long-term issues as opposed to only those impacting the issuer during the term of the bond. It also called for bondholders to collaborate more effectively at debt origin.   

The IIGCC also plans to facilitate more effective stewardship, says Pfeifer, by helping bondholders “to understand which levers they can pull at each stage of the financing lifecycle, and how these levers may differ when engaging with emerging market high yield or investment grade issuers, or between publicly-listed and private companies”.   

The investor network’s new Bondholder Stewardship Working Group will be chaired by Chandra Gopinathan, Senior Investment Manager of Sustainable Ownership at UK-based pension fund Railpen, and will consist of two workstreams: Bondholder Engagement and Financing Structures and Frameworks for New Issuances.   

The Bondholder Engagement group will focus on developing engagement guidance for bond investors which will supplement the IIGCC Net Zero Stewardship Toolkit , while the other working group will be more broadly developing and advocating best practice standards for scaling green financing in debt.  

In September, the UN-convened Principles for Responsible Investment (PRI) launched the Collaborative Sovereign Engagement on Climate Change initiative, which aims to facilitate engagement between investors and governments to mitigate the impacts of climate change by realising the value of sustainable sovereign debt investments.  

The first main area of focus is Australia, which the group noted is at a “critical juncture” for engagement to support climate policy action, following the introduction of the Climate Change Act.   

The PRI is also involved in the Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) project, alongside BT Pension Scheme (BTPS), the Church of England Pensions Board, Net Zero Asset Owner Alliance (NZAOA), Ceres, IIGCC, the Transition Pathway Initiative (TPI) and Chronos Sustainability. ASCOR aims to create a practical tool to support investors in their assessment of sovereign climate-related risks and opportunities.   

There are more developments in the pipeline, with CA100 in the process of reviewing its next workstream and the NZAOA gradually expanding its decarbonisation focus across asset classes.  

Issuers beware! 

In Q3 this year, then-UK Prime Minister Liz Truss proved the bond markets had lost none of their ability to intimidate since Clinton advisor James Carville noted their omnipotence in 1994. But they are not yet flexing their muscles to their full extent to scare issuers into accelerating their net zero commitments.  

In a recently published guide, Responsible Investment in Fixed Income Markets, former Pictet Senior ESG Specialist Arabella Turner highlights how bondholders can overcome the fluctuating nature of their influence on issuers, in part through greater collaboration, including with equity holders.  

“In practice, this may mean lobbying at bond roadshows in addition to AGMs, ensuring that representatives from both bond and equity investment teams are present at company meetings, and engaging with investor relations representatives in addition to senior management and board members to maximise internal awareness and debate across the issuer,” she wrote.  

The initiatives flagged above will soon give investors the tools they need to engage with greater force. On the sovereign debt front, ASCOR aims to develop a free open database that will help investors to assess and solve issues surrounding climate-related risks and opportunities. It will also publish a consultation on its proposed framework early next year.  

“We’re hoping our work will raise awareness and prompt conversations around sustainable sovereign debt and how investors can identify opportunities in different countries,” says Victoria Barron, Head of Sustainable Investment at BTPS. 

At BlueBay Asset Management, Ngo says there is a need for more decision-useful climate-related data from debt issuers so investors can more effectively evaluate risk exposures, and how these are being addressed. “As well as information which tells us how well an issuer is mitigating climate change, we want to know how resilient they will be, and how they will ensure a just transition. ESG-labelled issuance disclosure and reporting is another area where improvements can be made,” she says.  

For now, there remains “significant untapped potential” for bondholders to prioritise climate-related engagement, Pfeifer tells ESG Investor. 

“Thankfully, recognising that bondholder stewardship and engagement practices are far less established than equities, the industry is waking up to the great potential that bondholders have to affect change at companies.” 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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