The author is a bond portfolio manager at Berksdale Investment Management and co-author of Undiversified: The Big Gender Short in Investment Management.
Not to be outdone by the ESG Gold Rush, a growing number of bond firms now offer environmental, social and administrative funding. ESG integration has become a standard box that can be checked (or not) at the request of bond clients. Investment banks have developed tools to help fixed income managers ESG-ify their portfolios.
Yet the nature of lenders’ relationship with the structure and management of the corporate bond market suggests that the ESG playbook needs to be rewritten if bondholders want to make a difference in corporate behavior.
To avoid doubt – I believe that good E, S and G exercises can be consistent with higher income. As a co-author of a book on the importance of gender diversity in investment management and a shareholder and employee of a majority women-owned firm, I am an obsessively enthusiastic “S” and “G” advocate.
Despite our commitment to diversity and frequent research into ESG strategies, the firm I work for is, of course, not an ESG manager. We do not tell our clients what should be in a socially responsible portfolio. Our firm must balance client requests with the resources needed to create a relevant, marketable, compliant-compliant ESG framework.
These resources do not necessarily reside in small firms, as the company is just one of the few tools for research outperformance. In equities, alpha – or the ability to lose market – is about good stock picking. In the case of fixed income, Alpha includes portfolio sensitivity to interest rate management, sector allocation and best bond selection in the capital structure.
To analyze whether Apple is a good stock, a firm may hire an analyst who is solely responsible for covering the technology sector. But calling on Apple Bonds could fall on an analyst who oversees several large sectors, or a corporate bond expert who looks to determine relative values across all industries.
The structure of the investment-grade research process has led some bond shops to generate rankings using ESG ratings available in Bloomberg from a variety of sources. But in contrast to credit ratings, these are still inconsistent, and sometimes contradictory, in their ability to identify good corporate practices.
Bond investors do not accept credit rating agencies in their words on the quality of a company’s financial health. Telling a potential client that credit ratings drive portfolio building will not help them win a client mandate selection. But this method has worked for some managers when using ESG ratings.
One argument for ESG investing is that sustainability-minded investors can influence a company to make positive changes. But fixed-income managers don’t vote in stocks, and engaging with management is usually a new issue confined to “roadshows.”
Lenders have two (so far less used) tools to influence corporate strategy. We could boycott the new bond issue. But breaking our new-issue habit will be difficult. Portfolios need to be regularly reinvested in cash for coupon payments and bond maturity. New-issue calendars are not always aligned with the ESG shopping list.
Our second tool will be the agreement which requires adherence to certain ESG goals or progress. This requires a fundamental change in the bond agreement. Investment-grade bonds have minimal contracts, while high yield contracts focus on balance sheet metrics.
Companies have given us a weaker version of this, including “ESG bonds”. But unlike a traditional bond agreement, which requires consent at the corporate level, for an ESG bond only its issuer has to invest money for contractual use. And even that is somewhat considerable.
Where does the fixed income go from here? On the optimistic side, we work with our equity adversaries to present a unified front in dealing with companies while engaging more with ESG rating agencies. More resources are needed for this approach against the backdrop of increasing fee pressures and technology costs. And it ignores the possibility of a conflict between bond and equity perspectives and priorities.
I am hopeful that the thoughtful discussion of ESG in the bond portfolio which easily avoids box-ticking will lead to a meaningful evolution of our investment process. But I am skeptical about whether what has happened to fixed income to date has made much difference in the world. Bond portfolio managers must change their approach to ESG policy if they want to influence corporate behavior.