The power of ESG in fixed income
While environmental, social and governance (ESG) analysis has become prevalent in equity strategies over the years, the implementation in the world of fixed income (FI) has only recently begun to gain wider adoption. Investors across the globe, are now recognizing that ESG considerations are necessary to manage risk in their fixed income investments. In an asset class typically known for capital protection, ESG and sustainability are important determinants for that protection. For example, Volkswagen Group, the German automaker that was once the darling of sustainable practices has become a business with one of the worst credit scores after they were caught for falsifying data in a widely publicized emission scandal.
From the perspective of an institutional investor (and its beneficiaries), sustainability should be considered in three ways: fiscal, environmental and social responsibility. As fiduciaries, we want to ensure investment returns are enough to provide for the future, that generations to come will be able to live in a world where they can continue to enjoy the outdoors, and that there is equity and equality throughout.
To this end, the global fixed income market is much larger than its equity counterpart, and therefore has the potential to make a significant impact and drive sustainability forward, beyond just financially. We are already seeing the evidence of this: two years ago, Barclays PLC pledged to no longer provide new financing to private prison companies, but when it was announced the bank was the lead underwriter of a municipal bond deal for two Alabama prisons, they withdrew from the offering after becoming embroiled in a massive scandal. We want companies and governments to be accountable, and fixed income can play a huge role in progressing this forward. In fact, the fastest growing area of the asset class last year was not government or corporate debt, but rather sustainable bond issuance. A record U.S. $732.1 billion of sustainable debt was issued in 2020, increasing by 29% from the previous year, with social and sustainability bonds jumping sevenfold to U.S. $147.7 billion.
Sustainable bond opportunities rising
The rapid growth is already creating new opportunities for institutional investors, particularly here in Canada. While focusing on mainly environmental causes (for now), companies are issuing debt that integrates target-setting sustainability goals. Telus Corporation, for example, recently issued a bond linked to reducing greenhouse gas emissions, and if its company-wide target is not met, there would be penalties, while Bell Inc. and National Bank have issued similar sustainably-linked credit. On the social front, BMO issued a C$750 million Women in Business bond earlier in 2021, in support of an inclusive economic recovery that assists women-owned companies in Canada.
Transition bonds, in particular, are also expected to make their mark in Canada, since our economy is heavily weighted towards natural resources like oil and gas. The transition to renewable energy is due to spark massive CO2 reduction, and one of the ways the investment industry can support this is to issue debt specifically allocated to ensuring energy consumption is from renewable sources, which will encourage the shift away from fossil fuels. This type of narrow focus is unique to bond markets, where it’s possible to zero in on a target for an issuance that is helping the environment and moving towards a better future. Our team is anticipating greater appetite for sustainable corporate bonds as a result, particularly with the market driving lower financing costs for this type of debt.
An active ESG FI strategy to beat the benchmark
At BMO Global Asset Management, we’re leading the charge with the launch of a new BMO Sustainable Bond Strategy, an active strategy that truly digs deep into ESG factors of the select credits in which we choose to invest. To start, we specifically exclude bonds from the energy and pipelines sectors (with the exception to transition bonds), along with tobacco and firearms, and the debt of any company that is in the bottom quarter of MSCI’s ESG ratings. This type of sector exclusion – compared to an underweight position – is unique in the market, as it results in an approximately 60% lower CO2 emissions portfolio than the FTSE Canada Bond Universe Index benchmark, along with a higher overall ESG score. The bottom line is that we seek the best corporate bond opportunities from our investable universe, with the aim of delivering an overall higher yield than the benchmark.
A great example of our investment approach is with our recent participation in Bell Inc., and the Canadian telecom company’s first $500 million sustainability bond offering in May. This marked a major milestone in its sustainable financing framework that provides ongoing reporting and transparency to investors. This includes annual updates on the allocation and impact metrics until an amount equal to the net proceeds are fully allocated to eligible green and/or social projects. The offering fully aligns with our objective to give institutions an opportunity to make a difference, while also benefitting from a stable, growing company whose ESG score is trending higher – ultimately leading to better outcomes for investors.
How we engage – and protect
Active ownership and engagement are an integral part of our process, and it is how we ensure there is no sacrifice to expected yield. We have a dedicated responsible investment (RI) team that meets with our issuers consistently, and engages with them over time on relevant issues to help them achieve ESG milestones – from creating a plan to reduce greenhouse gas emissions to implementing the plan and working towards the stated goals. Through constant collaboration with our RI team, our credit sector specialists also have access to a proprietary ESG credit score that assesses both qualitative and quantitative metrics, and filters out the immaterial noise, with a more nuanced approach that aligns with the UN’s Sustainable Development Goals (SDGs).
Overarching all of our active fixed income strategies at BMO GAM (including the BMO Sustainable Bond Strategy) will always be a rigorous credit selection process, based on in-depth, fundamental research. Our experienced fixed income team seeks companies with an improving leverage profile over the long term, capable of maintaining, or increasing, their credit rating. Our four-step process starts with forecasting using a factor input model, which then yields a credit spread scorecard. This is translated into an expectation of future prices and expected returns, which is followed by optimization, downside constraints and continuous risk management. We protect on the downside with a comprehensive framework that includes daily monitoring of positions and weekly reviews to identify and quantify all factor risks (from inflation expectations to market technicals), with active mitigation to minimize drawdowns. The result is a consistent and disciplined approach that considers ESG scores, credit quality, valuation and liquidity – and longer-term prospects including revenue diversification, financial stability, infrastructure needs and capital requirements. Our in-house research is then input into various analytical tools to allow for real-time information flow, and access to credit analysts globally.
Staying nimble is key – particularly now
Our diligence and ongoing engagement are critical to managing risk and drawing attention to potential issues. To achieve outperformance, we believe it is not just about seeking higher yielding bonds, but knowing when, and perhaps just as importantly, being able to sell before the market turns or any concerns are elevated. We strive to keep nimble in our approach as our clients need managers that can row the boat in this environment, and constantly steer the course. Interest rates will shift and volatility is in the air, so having an investment team that can dial risk factors up and down, take advantage of idiosyncratic opportunities and eliminate potential problems before they impact client portfolios could allow for higher returns over the long term.
Currently, we’re positioned with less duration than the benchmark due to rising inflation expectations. While we believe the market and the U.S. Federal Reserve are expecting more of a transitory period, we are anticipating it will last longer until there is any real clarity, causing the yield curve to likely steepen further. We’re also overweight on corporate credit, as spreads continue to be tight, but stable. As we look ahead over the next six to 12 months, continued solid economic growth is expected as the world reopens, which will likely result in corporate credit outperformance.
To help navigate these conditions, the BMO Sustainable Bond Strategy is ideal for an investor who wants to achieve sustainability goals in their fixed income portfolio, but at the same time, is not willing to sacrifice returns, ESG or not. Our comprehensive active management approach is how we separate ourselves from our peers, and it’s why we’re already seeing great demand for this mandate.
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