Fixed-income investors tackle GSS in depth
Immediately after completing their Fixed-Income Investor GSS Survey, Commonwealth Bank of Australia (CommBank) and KangaNews convened a panel of leading Australian fixed-income investors to discuss and add colour to the survey findings. Investors explain why they think as they do on green, social and sustainability (GSS) issues and share views on how the space may evolve in future.
ADVOCACY AND ENGAGEMENT
Craig There has been a shift away from negative screening, particularly in Europe, where even fixed-income investors are pushing more for the advocacy and engagement approach. Do fixed-income investors in Australia see value in this approach?
BISHAY Engagement is incredibly important for us. You have less say if you sell out of a name. Not only do companies need to know where we have concerns as fixed-income investors, but also we work very closely with our equities teams – which clearly have greater influence as company ‘owners’. This two-pronged approach is far more effective than simply selling out.
WARD We don’t have the benefit of an in-house equity team so we carry out a lot of engagement directly. Companies want to understand what investors are looking for, though – so we get a lot of benefit from engagement.
We might sit out of transactions if a company fails to meet a target it had previously committed to. When an investor sells out of a company because of ESG [environmental, social and governance] concerns it is important to tell the issuer when and why that is happening. This is where we as investors have the power to start changing corporate behaviour.
NUNEZ As fixed-income investors, we have less influence over a company than equity investors. We don’t always have access to company management, for example. Rather than starting the ESG engagement process as we are about to exit a transaction, we prefer to get involved up front. We feel this is the debt investor’s opportunity for influence.
If it transpires that the company doesn’t perform to ESG expectations this is a different story and one that can be addressed on exit. When coming in, we take the opportunity to ask detailed questions in the screening process. In the due-diligence phase we ask about reporting, management behaviour, employee treatment and other policies.
In some situations, we may ask for independent reporting. This information is not always easy to come by so we may ask issuers to provide a quarterly report on various ESG aspects we monitor, such as changes in employment practices. If we see aspects weakening we ask for an explanation. I acknowledge that this is not always easy though, particularly in the public bond space.
Peacock Does this approach change for repeat issuers?
NUNEZ Yes. But if they behave badly we still let them know.
SWAN At Cbus Super we take an advocacy and whole-of-portfolio approach. It is important to engage with the maximum amount of information and people, and doing so makes one think quite differently.
Craig Do issuers appreciate the importance investors place on the engagement factor?
PEACOCK I think so. There is certainly a heightened awareness of ESG and what an issuer is doing at the corporate level across the board. Where issuers see things less clearly is the value or benefit of looking at certifying assets or undergoing a labelling process.
This clearly needs to be something issuers do that is complementary to their actions at a corporate level. But the issuance-level consideration versus the larger corporate-credit perspective is an interesting dynamic.
YUAN It seems to be a bit of a gimmick to label a bond green while the rest of a business is not. It can be a bit superficial. Some governments in Australia may support coal mining but will still issue a green bond. The bond may do very well, but it would be nice if the issuer took on a more holistic approach. Perhaps the entire business would achieve a pricing benefit as a result.
Craig Only 30 per cent of survey respondents indicate ESG practices other than negative screening have a “significant” influence on their investment decisions. Does this seem typical to investors? Also, to what extent are different practices deployed across the range of portfolios within fund management firms?
YUAN It is quite simple for us. If we judge that the investment risk – including risk related to ESG factors – is too high, we will not invest. If enough investors deny funding to a particular project it won’t get off the ground.
BISHAY I manage dedicated sustainable funds as well as vanilla fixed-income funds, and I manage them similarly at a sector level – with over- or underweights by sector.
Dedicated funds have a hard screen to specific industries and to issuers that don’t meet our ESG thresholds. However, the vanilla funds can potentially invest in screened-out issuers for a short time if we perceive valuation compensates for the risk. As soon as the valuation becomes an industry-level credit spread, we’re out. ESG factors certainly have an influence on investment decisions and how we view pricing.
ESG approaches: beyond the negative screen
Negative screening is still the single most-used environmental, social and governance (ESG) approach across survey respondents – with 89 per cent of investors deploying negative screens and no other technique used by more than 52 per cent.
WARD We have been using negative screening for several years. Some years ago, when British American Tobacco was still an active issuer in Australia, I remember having an argument with a portfolio manager about its bonds. He was intent on not holding them largely due to personal ethical and moral views. There were more smokers back in the early 2000s and my view at the time was that we were going to get paid back on those bonds so why wouldn’t we hold them.
Investor sentiment – including mine – has certainly changed. We have a range of formal negative screens – tobacco, munitions, controversial weapons and the like – but we are seeing more client demand for positive screening, particularly from insurance clients. As debt investors, our priority is to ensure we get our money back. Positive screening picks companies that will be sustainable over the longer term.
We also want to invest in companies that will come back to market. We are developing tools that seek out companies that under certain scenarios – such as climate risk – might perform better than their peers.
THE ‘WHO PAYS’ CONUNDRUM
Craig One of the biggest issues the survey highlights is “who pays for this?” More than 60 per cent of investors say they will not pay any premium for labelled bonds, while lack of willingness to pay for improved ESG outcomes is the most-referenced single impediment to market growth. How do we get past this apparent impasse on pricing?
WARD It is an interesting question, particularly around investors not wanting to pay for the label. At QIC we don’t have dedicated responsible investment funds so we mix all securities in our vanilla portfolios.
We need to have a conversation with clients if certain securities underperform. We do a lot of work on performance attribution of green, social and sustainability (GSS) bonds and we are reaching the stage where for some, mainly corporates, we are comfortable sharing the cost of those labels.
Specifically, this means the cost of the second-party opinion or other structures that support the security. This cost sharing is through pricing during primary issuance.
We look at the performance attribution of labelled bonds versus a vanilla security of similar duration, and one point of interest in the last few months has been performance through the pandemic. While it has only been marginal, we have not found one GSS security that hasn’t slightly outperformed.
Initially GSS bonds outperformed because they had a specialist investor base and the notes were put in the bottom drawer. We are relatively comfortable that demand has now picked up. Book sizes are bigger relative to print volumes and there is some outperformance as a result.
We would like to see an improvement in quantitative reporting to be able to take this through to our client reporting. As such, we’re starting to get comfortable with the concept of contributing in some way to helping to fund transition – but also because we know these bonds can outperform.
SWAN From the perspective of a super fund, we want our managers to make these kinds of decisions for us. However, as we continue to internalise investment we increasingly need to make these decisions ourselves. What is in our members’ best interests and whether and for what we should be prepared to give up returns are the most debated topics.
Like QIC, we do a lot of work into like-for-like assets, including correlation work to ascertain whether performance is the same. The costs of underperforming are stark in investment-grade credits so we do all we can for our members to try not to underperform. If this comes at a cost of investing in these kinds of bonds, it is something we have to live with.
Having said this, one would hope that, over time, GSS securities should outperform. Cbus has also just announced a dedicated allocation to climate initiatives, which is one way around our ‘who pays’ conundrum.
PEARSON I am a little surprised at the 60 per cent figure. I would have expected it to be higher.
We have an ambition to invest US$2 billion in impact investment globally by 2025 and the majority will be in fixed income given the nature of our strategic asset allocation. Our process, though, is that an investment must meet the financial risk-return threshold before we will start to examine the impact. This seems to be echoed by our peers, which are also looking for the market-rate risk-adjusted return first.
Our fixed-income team and banking partners aren’t seeing issuers or investors trying to look aggressively at pricing. There is more of a focus on credit rating and positive impact, as well as the transparency and diversity that comes with investing for green, social or sustainability outcomes.
Moving beyond the marketing that comes with GSS bonds and looking for issuers to engage with us and produce higher-quality impact reporting that we can use is going to become a ticket to the game for this type of issuance. The free ride of issuing and getting a headline is no longer sustainable.
NUNEZ I am not sure yet that the investor market is ready to pay a premium for GSS bonds. From IFM’s perspective, the focus first and foremost is on the return for our clients in line with our fiduciary duties, particularly in the current environment of the pandemic.
The data point in the CommBank-KangaNews survey that suggests it will take at least two years before issuers with poor ESG performance will have to pay a material premium to access capital sounds about right to me.
BISHAY As everyone has mentioned, when asset owners or clients of ours allocate money to us the most important focus is performance. It doesn’t make sense for us to invest in assets with much tighter spreads that won’t necessarily perform in secondary relative to a vanilla equivalent.
Pendal’s dedicated responsible investment funds have two objectives: performance and to manage funds in a sustainable fashion. A tighter spread on impact bonds relative to vanilla bonds from the same issuer won’t happen until we get sufficient dedicated sustainable funds filling up deal books.
If 50-75 per cent of a book is filled by non-dedicated sustainable funds, these investors aren’t going to accept a tighter spread unless they know the bond is going to perform.
I don’t think Australia will get to where Europe is for a long time as dedicated impact funds are very small here relative to the rest of the debt market. This is very different from Europe where spreads can be tighter on issuance as the dedicated sustainable investor base is much larger than Australia.
For the many years in which I have been investing in impact bonds, only one issuer has achieved tighter primary pricing in Australia. The transaction priced a couple of basis points tighter than the vanilla curve and, if anything, it underperformed in secondary. We’re not going to pursue bonds at a tighter spread relative to the vanilla curve at this stage.
ESG research and analysis
A majority of investors say they use each of issuers’ sustainability and general reporting, in-house capabilities, rating-agency research and certification or verification agents to inform their environmental, social and governance (ESG) analysis.
PEARSON We rely on external research on financial and nonfinancial data. We use research to inform the first wave of screening, which may include various thresholds to help us filter down our universe. Compared with the fundamental research that is available in, say, the equity market, fixed-income ESG research information available is lacking.
There is consolidation in the market and a race for data with improved quality and accuracy. The frequency of the reports and coverage from ESG research providers is still wanting but the range of available information is improving year on year. I expect this to continue as investors are demanding it.
Some of the drive is coming from the issuers themselves. Listed entities such as QBE have a commitment to being transparent and to providing data to enable investors to make informed investment decisions.
Craig There was some, but not overwhelming, interest in the survey in sustainability performance-linked bonds (SLBs) and transition instruments. To what extent could finance that only rewards the successful achievement of future goals resolve the pricing challenge?
PEARSON Where I struggle with SLBs and transition instruments is the moral dilemma they present. As responsible investors, we are looking to generate market-rate, risk-adjusted returns and therefore the idea of benefiting from an organisation not meeting ESG targets doesn’t sit well.
Perhaps we can do something with an additional coupon payment that is higher because of missed targets. Something that has more of a positive impact, such as contributing the difference to the QBE Foundation.
SWAN Essentially it’s the market’s role to determine fair pricing – but realistic targets still need to be set on these instruments.
WARD We like the concept as it is a way of helping companies to transition. The ability to use these instruments for general corporate purposes should start to bring companies along.
But we also have some concerns. This is not a coupon step-up that compensates for a rating downgrade and the additional credit risk. There might be additional credit risk because the issuer has missed its targets, but really it is a windfall gain for investors because a company has failed to achieve its target.
When including these instruments in a pooled portfolio, we ought to take account of the views of the multiple investors that could benefit from the windfall gain. Some of them will value the extra coupon but it may not sit well morally for others.
BISHAY My concern is around an SLB where the issuer does not meet the sustainable performance targets and investors sell as a result. In this scenario, the question I must ask is whether the coupon step-up is sufficient compensation for the bond selling off.
The aim should be for the step-up to compensate for the sell off, as otherwise it will be painful for the investor especially because such an instrument would no longer qualify as a GSS bond. I’d be interested to hear what other investors think: let’s assume it’s a 25 basis points step up – would a bond widen by more than 25 basis points?
WARD I think it would.
BISHAY So, net-net as an investor, we don’t want companies to miss their targets.
YUAN It is still possible to achieve a pricing benefit – it’s just an indirect one. If you issue a green bond the book will likely be larger, and if the book is larger the issuer tightens the pricing more. As an investor, you get more pricing benefit anyway.
NUNEZ If the features in such instruments are not doing what they are designed to do, which is to encourage companies to perform sustainably, we would just be penalising our clients by investing in them. I’m just not certain the mechanism is appropriate as currently construed.
Peacock If a spread widens further than the step-up in these instruments, isn’t this positive insofar as there is an alignment of interest between investors and issuers?
BISHAY Absolutely. But my aim is to reframe how some people think about the step-up. Some view this as a windfall for investors if the company doesn’t meet its objectives. This is not the case: if the company doesn’t meet the objectives it has set for itself the bond is going to smell very bad.
PEACOCK The intent with the step-up – and to a certain extent the step-down – is that targets are set with a wide path for the issuer to traverse. The step-up is therefore designed to kick in if there is a material deterioration – it would have to be a very bad outcome for the issuer for that scenario to play out. Equally, if the margin were to step down it would imply that the issuer had materially outperformed its trajectory. The guard rails are wide and designed to cover an extreme market spectrum.
BISHAY It is important to ensure the sustainability objectives are not business as usual but stretched, though. If a company is trying to reach zero emissions by a certain time, that time can’t be a hundred years away if it is to have value.
Craig Does brown-to-green transition funding raise concerns about greenwashing or is it just that some issuers would fail negative-screen testing and be rendered unsuitable even for transition finance?
NUNEZ For us, a failure of negative screen test is the challenge. We have underlying clients that have said no to coal or other sectors within the portfolio. Even though we have seen some transactions with active strategies to transition away from a sector or commence with renewable projects or environmental strategies, it is challenging when clients are imposing a screening directive to the sector outright.
There may be some movement in the future and some clients may come around to alternative thinking. Let’s use power as an example. We can’t just say no to a company that is providing coal power to the nation but is also actively shifting to renewables, but we have to say no under a negative screen. We need to see active transition and we have to find a way to measure it and to articulate what should be a clear transition story to investors.
PEARSON As I mentioned earlier, a focus for QBE is the US$2 billion ambition to achieve in impact investments globally by 2025. The requirements are to meet risk-adjusted returns and to have a positive impact. It’s not about premia for ‘less bad’. As much as the transition to a low-carbon economy needs to be funded, our programme focuses on positive impacts. It’s not to say we wouldn’t own brown-to-green instruments in other parts of our fixed-income book, assuming they passed ESG and negative-screening criteria.
BISHAY One of the reasons I look at a transition bond differently from a green bond is that if I invest in a transition bond I am exposed, from an impact perspective, to the full company that could be producing a bucket load of emissions. If it changed the delta, which is what we’re all trying to achieve, I still have exposure to a huge amount of emissions.
If I am happy with the credit quality of the issuer my preference, without question, is a ringfenced bond to a specific project rather than general corporate activity.
WARD We would like to fund transition stories and to see companies bring emissions down over time. There is a lot of trust implicit in the targets that companies set as part of their transition plans. It is a bigger monitoring job than a labelled bond and explaining any slippage in timeframe to investors takes resourcing.
Peacock Where will this courage come from? In various parts of the survey we got a reasonably strong sense that member preferences are driving investment decisions.
WARD This is the case for some segregated funds. On the super fund side, rather than being driven by mum and dad superannuants, the trustees are taking more of an active interest in what they are funding. This is being driven by governance principles and the Modern Slavery Act.
ESG is part of the analysis process when we look at credit. We are effectively positive screening by knocking companies out where we aren’t comfortable with governance or some other practices.
A lot of the passion in getting comfortable with a transition story will come from credit analysts. As a credit analyst, I wouldn’t want to have to explain to portfolio managers why I supported this company but the rest of the credit investment universe didn’t agree with me. Part of the bravery will come from credit analysts pushing ideas through portfolios.
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