Edith Siermann, Head of Fixed Income and Responsible Investing at NN IP, says bondholders have equal responsibility for driving sustainability alongside shareholders.
Asset flows into sustainable fixed income funds increased by 2.4 times in 2021 to reach US$135 billion. While still far lower than the US$320 billion for equities, this indicates significant appetite for ESG funds from credit investors.
CRISIL – an ESG ratings provider which is part of S&P – attributes the recent momentum to fixed income funds playing catch up to their equity counterparts, noting also that regulations around product labelling, especially the Sustainable Finance Disclosure Regulation (SFDR) “are acting as catalysts to the expansion”.
CRISIL says there is now an opportunity for asset managers to capitalise on the “under-penetrated” ESG fixed income market which represents just 3% of global fund assets.
“We believe a multi-fold rise in the supply of sustainable debt across issuers, coupled with regulatory catalysts, have created a favourable environment for asset managers to expand ESG integration within their fixed income portfolios,” it said in a recent report, predicting that a surging green bond issuance market – expected to increase 5x to US$5 trillion over 2022-25 – will provide “much-needed firepower” to sustainable fixed income investing.
This greater interest in applying ESG criteria to fixed income investments is positive news for NN Investment Partners, the Dutch-based multi-asset manager which has €301 billion in assets under management, of which 91% is invested based on its ESG framework.
The NN IP framework consists of four pillars – business model, governance, environmental and social – each focused on themes that “help assess a company’s real-world impact”. The themes encompass a range of material issues including sourcing of materials; water management, biodiversity and land use; and pollution and waste.
Analysts assess how significant each issue is for the 24 industry groups covered by the framework.
Edith Siermann, Head of Fixed Income and Responsible Investing at NN IP – which was acquired by Goldman Sachs in April this year – says: “We do not differentiate between equity and credit, because the material factors for an industry group are the same regardless of asset class, even though the magnitude of their financial impact may differ.”
Engagement is a key part of NN IP’s sustainable investment strategy, and Siermann argues there is no reason why bondholders cannot exert the same influence as shareholders over a company’s behaviour – and ESG performance in particular – despite having no voting rights.
She says: “It is often assumed that a bondholder has a completely different relationship with the investee company than the one a shareholder has. That is not true. We strongly feel that the only real difference is that we’re not allowed to vote.”
Siermann continues: “Companies need bondholders to finance them and so they are often in a good position to engage with companies, and they are seen as very relevant.”
This argument is reinforced by a 2021 Russell Investments ESG manager survey covering 369 managers which found 92% of fixed income managers regularly engage with the underlying holdings in which they invest.
When comparing the responses over the past three years, fixed income managers show the largest year-over-year increases in engagement as more bond managers are incorporating engagement activities.
However, ratings agency CRISIL says that compared with equity investors, bondholders have to rely on pre-issuance management – in other words meeting with companies before they buy any bonds.
They also argue that fixed income investors have “limited access to management post-issuance to drive ESG goals”, and they are reduced to “reactive engagement”.
Siermann refutes these points, claiming that her fixed income team has just as much clout as that enjoyed by the equity desk both before and after they have invested.
“On climate we have the same interests as our equity team. For investment decisions, we might ask different questions because on the credit side we are typically focused on the downside risk while our equity colleagues are looking at upward potential,” she says.
“Perhaps we translate the answers differently for investment decisions, but our questions will be very much the same. Is a company committed to net zero? If not, then why and what is holding them back? We do not experience any difference in responses whether it is a credit or equity analyst asking the questions.”
She also notes that the credit and equity sides can join forces to have even greater influence over the companies in which they invest.
“We team up with our own equity colleagues and with other investors. As asset owners and as managers, the more powerful we are then the better positioned to engage successfully,” Siermann says.
While Siermann is confident that fixed income investors enjoy a comparable engagement experience to that of equity investors, she acknowledges there are challenges in gathering requisite ESG data, particularly from high yield issuers and those in emerging markets.
“Companies in the high yield and emerging markets universes are not used to responsible investing. They are often not disclosing much, and they are not forced to disclose by regulation. This is part of the conversation we need to have with them to encourage them to share more data.”
CRISIL’s analysis of more than 400 global bond issuers shows that only 75% of high yield or non-rated firms reported Scope 1 and 2 emissions measures, compared with 95% for investment grade firms. Only 39% of emerging market issuers reported water-related emissions, compared with 55% on average for issuers in key developed markets.
This lack of reporting will likely prove problematic for the growing number of investors interested in allocating to high yield and emerging market debt while looking to manage ESG risks and impacts.
A survey by Swiss asset manager Vontobel of 342 institutional investors found 24% of UK respondents say they expect to decrease allocations to developed market fixed income in the next 24 months in favour of emerging markets, which they say proffer greater liquidity and diversification.
However, respondents also say that ESG data inconsistency by third-party providers (62%), scepticism about the positive impact of ESG investments (61%), the perceived higher risk associated with emerging markets fixed income (43%) and the lack of suitable ESG offerings from external asset managers (43%) present barriers to investment.
Siermann says it is not just the emerging market and high yield spaces where it is difficult to gather data.
“We do have challenges with sovereign issuers. They are happy to impose regulations on corporates but there is still some work to do getting data from governments themselves.”
She adds that while the SFDR offers guidance on corporate bonds reporting, it is not clear on sovereign debt.
“The focus within SFDR is very much corporate. When it comes to rules or guidance around how to cope with sovereigns, then it’s very limited. As we understand it, a sovereign cannot be considered sustainable and that hampers when creating Article 9 [a fund that has sustainable or a reduction in carbon emissions as its objective] classified products.”
However, NN IP has developed a Sovereign Lens tool which provides a single ESG score based on whether a country’s efforts to make progress towards the UN Sustainable Development Goals could boost returns.
This tool helped NN IP launch a sovereign green bond fund last April, classified as Article 9 under SFDR.
European government debt – notably France, Germany and the Netherlands – dominate the portfolio, although there are small allocations to Chile and South Korea.
The sovereign green bond fund is one of four funds in NN’s green bond portfolio, reflecting a growing appetite from investors.
In May, the Climate Bonds Initiative revealed the green, social and sustainable (GSS) labelled debt market raised US$202 billion in the first quarter of 2022.
This pushes cumulative GSS-labelled debt volumes past the US$3 trillion mark, which the initiative calls “a solid milestone”.
Siermann says green bonds are important for ESG investors since they have a greater say in how the proceeds of that bond are put to work.
“With a green bond the money must be ringfenced for a certified green project. You can really dig into that project and understand its progress. For us a green bond is a pure impact investment,” Siermann says.
Fixed income may lag the equity space when it comes to ESG investing but it is catching up fast. As investor appetite for sustainable credit grows and legislation such as the SFDR beds in, bondholders will only see their influence grow when it comes to driving the ESG agenda.