Fixed income and impact investing – fashion or fundamental change?

June, 2017 Print

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Alexandra Noble, Director, Noble & Associates.

Alexandra Noble of Noble & Associates looks at how the investment landscape is changing for ethical investors


Impact Investing, despite being a relatively new term, is rapidly becoming a vogue topic. The concepts of Responsible Investing (RI) or Ethical Investing have long been established principles for a significant sector of investors. Having roots back in the 19th century with the ethical motives and principles of great Quaker industrialists such as the founders of Barclays Bank, Bryant and May, Cadbury, Clarks, Rowntree and Lloyds Bank. Although their ethical origins have largely dimmed, there is little doubt that these principles underpinned their early years and contributed to their longevity (with the notable exception of the banks!) In more recent times, this concept of the “ethical entrepreneur” has morphed into being applied to the joint-stock company and Socially Responsible Investing (SRI). This is now often used as an umbrella term for Environmental, Social & Governance (ESG) which stands alongside the term “Impact Investing”.

Investors can have a multitude of motives and reasons other than purely financial return for evaluating whether or not to invest in any particular opportunity. SRI became an investment criteria with investors who were principally motivated by seeing their decisions being based on what they considered to be ethical considerations. For example, tobacco companies and armament manufacturers have been broadly regarded by SRI-motivated investors as being off limits. Then, after the end of the cold war and the emergence of climate change as the new global threat to humanity, investors began to consider environmental issues such as carbon, waste management and recycling. There was also what might be termed the social agenda which embraced human rights, working conditions, diversity, ethnic discrimination and fair trade – all of which became important criteria on the checklist of many SRI investors. Following the global financial crisis of 2007/8, and the moral hazard it revealed to investors, the general topic of governance has also emerged as an important investment criteria, and has subsequently come rapidly to the fore. This covers such areas as corporate governance, business ethics, corruption and board diversity, experience and competency. The global financial crisis appears to have finally awakened investors to the need, and indeed fiduciary responsibility, to become more informed and engaged in those companies in which they have made a financial investment, in order to encourage the management and boards of companies to be open, transparent and accountable to their owners and increasingly their lenders.

How fast are we moving?
There has been significant change over the last 10 years. Much of this has resulted from the pro-active approach of a number of large institutional managers and asset owners who have been at the forefront of RI and Impact Investing. This group has been particularly vigorous in expecting and insisting on high standards of corporate governance in the companies in which they invest. These ground level initiatives were further reinforced when, in 2006, the United Nations (UN) launched its six general principles for responsible investing and established that, on a global basis, environmental, social and governance issues are material considerations which should underpin all investment decisions. It is known as the “UN PRI” and, as at June 2017, has attracted around 1,700 signatories accounting for an aggregate portfolio of assets valued in excess of $60 trillion.

Over recent years, SRI and Impact Investing has grown considerably as a talking point. This has led to companies sharing research and creating education programmes to promote an understanding of the benefits of ESG considerations across the investment spectrum. This anecdotal and formal sharing within the investment community of the challenges and developments in different sectors, has led to a significant deepening and general awareness of the importance of SRI. In 2011 the World Economic Forum’s Global Risk Report was dominated by environmental issues indicating that ESG and SRI considerations were beginning to become mainstream. Then, in 2014, the UK Law Commission Review of Fiduciary Duty put responsible investment and stewardship firmly back on trustees’ agendas. And in December 2015, with the signing of the Paris Climate Change agreement, a new and shared set of goals for the planet was placed before the investment community.

Reliable and quality ESG data is becoming more readily available. For example, as a result of the increased availability of data from Morningstar, Bloomberg and MSCI, many fund managers are beginning to integrate valid ESG data and analytics into their investment reporting. ESG is now a mainstream activity with asset owners and institutions specifically allocating capital towards impact investments that create social and environmental value and where there is evidence of improving corporate governance. ESG experts are now being incorporated within portfolio management teams rather than being regarded as an optional add-on specialist area. So it is clear that ESG considerations are becoming an essential and intrinsic part of the investment process. This will continue to grow, and probably at an accelerated pace to meet the investor demand which, in turn, is being underpinned by changing public and political opinion.

Where next for ESG and fixed income?
The fixed income portion of portfolios has long been the cornerstone of creating a traditional balanced portfolio to generate stable and predictable returns, with less volatility and risk than an equity portfolio. There is also a case to be made that the tumultuous world of the last decade is unlikely to subside soon and therefore, as ESG bonds show less correlation with other asset classes, they will probably provide further diversification. So it follows that with the growth of interest in impact investing, institutional investors will also expect to find opportunities in fixed income which will provide them with the positive economic, social and governance attributes they seek. It is clear that investment managers are responding to client demand and offering a variety of instruments and funds, showing it is possible to align investors’ goals with having a positive social and environmental impact.

There is a rapidly growing range of investment opportunities across the ESG fixed income/credit universe, encompassing different impact strategies, geographies, and sectors: sustainable bond funds; social impact bonds (SIBs); development impact bonds and green bonds to list but a few. It is worth mentioning that “green bonds” are a relatively new product and as such, there are issues around the development of reporting standards to enable valid comparisons with other bonds. It even raises the question of whether or not a bond can actually qualify as “green”. There is a danger that in the current situation where impact investing has become fashionable, that if a bond has “green” in its title, then this qualifies as a genuine social impact opportunity. That is clearly not the case. Whilst there are two main “green” standards (developed by The International Capital Market Association and the Climate Bonds Standard), China has issued its own standard. This lack of alignment has resulted in uncertainty for investors. Despite this, the signing of the Paris Climate agreement in December 2015 has resulted in the issuance of green bonds growing significantly, and in the current year their value is expected to reach between $100-300 billion. Needless to say, this is a very small fraction of the total issuance of government and corporate bonds worldwide, but it does indicate a trend and that there is a clear appetite for this kind of SRI instrument which, as yet, supply cannot adequately meet, despite a flurry of activity and with new funds being launched earlier this year.

Is there reliable data and ratings for fixed income investors with an ESG mind-set?
This is an important topic which is vital to underpinning any sound ESG investment decision. Whilst there are a number of providers, many focus on just one area of ESG, for example governance. There are a number of approaches and currently, the two major ESG providers of data are MSCI and Sustainalytics. A number of reports have been written which confirm, perhaps contrary to conventional wisdom, that historically, ESG corporate bond portfolios have tended to outperform.

ESG rating providers also measure the risks associated with negative events which may result from a lack of adherence to ESG. There is a need for additional information to consider the risks, which might impact, either directly or indirectly, on a corporation’s sustainability. For example, the risk of pollution causing high environmental damage, or a change in regulations, which may impact governance procedures.

But despite the growth in the sector, the challenge of actually collecting relevant data and analysing and interpreting it, should not be underestimated. Validating issuers ESG credentials is not easy. But as the sector is growing, and growing quickly, it is expected that issuers’ attitudes will continue to change considerably and that ESG transparency will become more widespread, as is evidenced by the fact that many large corporations are voluntarily providing environmental policy statements in their annual report. Indeed, there are a number of bodies currently working towards mandatory reporting standards for this non-financial information, including the Sustainable Accounts Standard Board (SASB), the Global Reporting initiative (GRI) and Sustainability Investor Forums.

Also, a number of organisations are looking at how to define standards for the reporting of non-financial information. As it is investors that are generally funding the providers of ESG data, there is less likelihood of conflicts of interest and this should mean that the resulting ratings are better aligned to meeting the investors quest for reliable, independent and qualified assessment.

Conclusion
“Impact Investing” may indeed be in vogue, but in my view and that of many others, it is here to stay. Impact investing is fast growing in importance and is expected to continue to bring further change to the investment terrain. The industry of ESG providers is proliferating and with the push for mandatory reporting and active engagement in all three areas, institutional investors will continue to ensure that ESG remains and becomes entrenched as an essential ingredient of the investment process. The LGPS investment community needs to make sure it gets up to speed with this important change in the landscape.

Fixed Income FOCUS

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