How to decipher the most difficult asset classes for ESG

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Environmental, social and governance strategies abound in stock markets, but applying ESG principles to fixed income securities can be much more complicated. With a new report, consultancy firm Willis Towers Watson seeks to help asset owners better integrate ESG into fixed income portfolios.

The study, which is expected to be released on Monday, details the risks and rewards of ESG across four fixed income subsectors: corporate credit, sovereign debt, asset-backed and securitized credit, and private debt. Of the four, corporate credit has seen the most progress in its ESG integration, while private debt may offer the most opportunities for asset owners, according to the study.

“Fixed income is such a complex asset class; it’s not as simple as stocks, ”said Nimisha Srivastava, global credit manager at Willis Towers Watson and co-author of the report, in an interview. “You have to be pretty specific about fixed income securities because, whether it’s corporate bond or country debt or securitized credit instruments, they’re all very different. “

Where ESG is “easiest”

According to the report, the relative success of corporate credit in ESG initiatives can be attributed to four factors: “the similarity of issuers and risk factors to equities, as many issuers of equities also issue debt; greater transparency, if the debt is issued by public enterprises; and other supporting evidence showing a positive link between ESG and corporate bond performance. “

“This is the easiest part of the fixed income universe to consider ESG because it has more similarities to stocks than anything else,” Srivastava said. “So that means the bar is higher for what managers can do in this area.”

However, while corporate credit has hindered ESG integration, challenges remain for the sub-sector. For example, transparency is an issue for small private companies that issue debt.

“The complexity of corporate debt (varying by maturity, ratings / quality) has made the ESG link to bond performance difficult to pull off, with a lack of long-term data,” Willis Towers Watson said in The report.

The best managers in the field have taken a security and sector approach, according to the report. The most successful managers have established their own internal ESG rating systems, which help fill the “gaps” that “often exist among providers of external ESG ratings,” the report said.

When assessing the ESG integration of corporate bond managers, Srivastava suggests that asset owners ensure that there is a strong framework for managing risk, an ESG rating system. internal, a wide range of ESG resources and sufficient ESG training programs for bond analysts and portfolio managers.

“Managers really need to have their own rating or their own take on ESG,” Srivastava said. “If they do, we think they will naturally recognize ESG risks. ”

“More demanding” asset classes

When researching ESG data on sovereign debt, asset owners may discover that most of the information relates solely to governance, according to the report. As data providers begin to acquire information on other elements of ESG practices and risks, Srivastava said the lack of information made it a “more difficult” area for ESG integration.

Willis Towers Watson suggested that asset owners ensure managers focus on factors beyond governance and are leveraged in countries’ low carbon transition, which is a “key opportunity for top managers.” sovereigns ”, according to the report.

“In our opinion, the best-performing approach has evolved into a better understanding of what this country is doing in terms of decarbonization plans or improved governance,” Srivastava said.

Then there is asset-backed and securitized credit, a “complex” market that offers less transparency and liquidity compared to other sub-sectors, according to the report. Like sovereign debt, asset-backed credit has an information problem, which means that rating agencies have little to offer when it comes to ESG data.

“This is the most difficult segment of the market to consider on the value of ESG integration as there is often no choice,” said Srivastava. “If you buy a commercial mortgage pool, there could be 20 underlying properties in that pool. Let’s say 18 of these properties are considering green energy improvements. And let’s say two of those properties were using unfair labor practices. There isn’t much you can do about it. “

In order to navigate this difficult sub-sector, Willis Towers Watson recommends that asset owners ensure that lenders have governance frameworks that include fair and transparent lending practices, prudent loan underwriting and solid service. , while allowing an alignment of interests between managers and borrowers.

The opportunity of private debt

The last sub-sector presented in the report was private debt. According to Willis Towers Watson, private debt managers have a long-term view, which means they want to follow long-term market trends like ESG. The authors of the report said they expected private debt managers to have a “deeper understanding” of the importance of ESG strategies compared to public debt managers.

“We believe you can have the most impact on private debt,” Srivastava said. “If you’re a private lender lending to a private business, you have a lot of power. ”

When seeking to embed ESG into private debt, asset owners should ensure that the manager has a sustainable and sound investment policy, take steps to ensure shareholders are treated fairly, and follow a range of ESG metrics on each loan, according to the report.


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