Why is the integration of environmental, social and governance considerations (ESG) important in fixed income?
Written by: Angelique Kalam, Manager Sustainable Investment Practices
Firstly, fixed income managers are not absolved when it comes to applying ESG to our fixed income portfolios. Regulation 28 of the Pension Funds Act requires pension funds to consider all issues that could materially affect long-term performance, including ESG factors, in keeping with our fiduciary responsibility we can demonstrate the value to our clients.
Secondly, there’s a strong case to support the inclusion of ESG in fixed income because it offers fixed income managers another lens (in addition to credit and financial analysis) for identifying, managing and ultimately pricing for these non-financial risks.
Let me demonstrate this by taking you through our philosophy and approach.
Philosophy and approach
We seek to promote sustainable ESG best practice in our investee companies. We believe that ESG issues are key components in managing investment risk. A lack of attention or management of ESG issues can have a negative impact on risks and rewards - as evidenced in many recent headlines relating to governance failures in the South African market, such as African Bank and Steinhoff, to name a few.
Applying ESG analysis to Fixed Income
Our primary objective is to earn appropriate risk-adjusted returns at all times for our clients. As such, it is necessary that ESG screening and analysis forms part of an integrated investment process across our wide range of mandates. In this way, non-financial indicators are assessed along with financial and credit indicators in order to produce a holistic risk profile of any new or existing loan, at a given point in time. We use a variety of tools and inputs for this purpose, and these are constantly fine-tuned as new learnings arise.
The fixed income asset class is complex due to the wide variety of issuers, and therefore there is no ‘one-size-fits-all’ solution to analysing companies on sustainability issues and analysts have to apply judgement in their analysis. Therefore, there will be variances in our approach to, for example, issuers in the listed space versus those in private debt. We also recognise that companies are at different stages in their business lifecycle and we have to be realistic in our requests and recommendations. We therefore engage with these companies to reach a mutually agreed outcome that will benefit both the business and the investment.
Some examples of screening criteria could include:
- Does the company assess the environmental risks arising from its operations, what processes are in place to do this and how does it mitigate these risks?
- How are these risks managed and reported to the Board?
- What impact do the company’s activities have on local communities and other stakeholders?
- Does the company engage its supply chain on material sustainability issues relating to its business risks; and if so, is there a measured outcome required by the company on the issue?
- Does the company routinely disclose material transactions that involve conflicts of interest of any directors, and any fines or regulatory non-compliance – and is there a record of how these situations have been addressed?
- Does the Board of Directors have a transformation plan in place, what is the plan and what are the timelines to address the lack of Board diversity?
Embedding protections for client funds
In addition to the above, we seek to embed strong protections for our clients. Through our large skilled credit team, we are able to negotiate specific terms in loan agreements on behalf of our clients - and have the added benefit of being able to structure many of these loans internally. As lenders, we seek strong covenants in order to protect our clients during the term of a loan. For example, we require borrowers to report timeously on any material events that could affect the credit quality of the loan.
Examples of such events could be reputational damage to the company due to a failure to respond timeously on poor product quality that resulted in harm to consumers, extreme weather incidents that caused unforeseen production losses, or unanticipated expenditure relating to health and safety non-compliance, amongst others. On these occasions, we engage the borrowers to ensure that the risk is minimised as far as possible, and, importantly, that long-term, proactive strategies are devised and implemented to manage the risk and the impact on future revenues. Learnings from these events are shared internally and applied across all our investments, where applicable, to the benefit of all our clients in the end.
Additional ways of adding value
Some other ways we add value in the way we manage our various funds are highlighted below:
- As stated above, in our negotiations with borrowers, we seek strong covenants on loans to help protect our clients’ funds during the term of the loan.
- We stay involved throughout the term of the loan, often receiving monthly management accounts and attending quarterly meetings where we have the opportunity to engage management on an ongoing basis.
- Where appropriate, we participate in various committees conducted by the investee company (e.g. lenders’ committees, boards) where we engage with senior management on these issues.
Corporate listed bonds
- In addition to seeking better protections and terms for our investors, through our collaboration with ASISA, we seek to raise standards in the domestic bond market, advocating for better covenants, and stronger negative-pledge conditions and security.
In our rapidly changing environment, where responsible investment practices like ESG are gaining momentum and evolving, the financial services industry continues to grapple with risks of an ESG nature. We believe that our focussed and dynamic approach has set us apart in this field. We add value to our clients’ portfolios by integrating ESG into our investment processes and engaging borrowers on material issues that affect the sustainability of their business. We also strive to add value to our industry by engaging the market around improving capital market standards, while being mindful of the issues summarised below.
- ESG risks can impair an issuer’s credit quality.
- There is no standard set of ESG risk parameters for fixed income; it differs across issuers and sectors.
- ESG is full of judgement and biases; as managers we should exercise judgement.
- Build investment processes that earn sustainable returns.
- ESG should never compromise risk: return principles.
Futuregrowth is a proud signatory of the UN Principles for Responsible Investment (PRI) and endorses the Code for Responsible Investment in South Africa (CRISA).