18 December 2019
By John Godley, Co-Fund Manager HC Verbatim Portfolio 5 Income Fund
2019 has seen a mass change in climate consciousness with activists such as Greta Thunberg and the Extinction Rebellion group achieving household name recognition. In UK corporate bond markets, it is really the first year in which the notion of responsible bond investing has moved to the top of client priorities.
But what exactly does ‘responsible’ mean? In brief, it means marrying analysis of environmental, social and governance (ESG) factors to traditional financial analysis when deciding which companies to lend to. Since adverse ESG developments can lead to material underperformance of an issuer, it is expected that this will lead to superior long-term returns.
The notion of ethical investing goes back hundreds of years when it was associated with the Church. More recently, its evolution can be traced via the mass divestment by professional money managers from apartheid South Africa in the 1970s and 1980s.
Ethical investing 2.0
Bond investors’ first major encounter with ESG risk was in the mid-1990s when tobacco credits experienced severe stress due to a wave of State-level litigation in the US. Next came the accounting scandals of the early 2000s (Enron, WorldCom, Tyco, etc) which revealed glaring governance issues across corporate America.
More recent instances of ESG failure include the Deepwater Horizon oil rig disaster in 2010 (BP) and the defeat device scandal in 2015 (Volkswagen). Both episodes resulted in severe underperformance of the companies’ bonds. Rigorous ESG analysis does not guarantee that an investor can always avoid treading on such landmines. However, it does allow an investor to better gauge the credit risk premium, or spread, on the bonds that adequately compensates not just for risks related to the strength of the company’s balance sheet, but also for the contingent risks that may arise from ESG factors.
For example, a five-year Volkswagen bond in GBP yielding only 0.7% more than UK gilts – as it would have done in early 2015 – might not be attractive enough for us to have considered owning, given the high degree of ESG risk associated with the auto sector. On the other hand, a Volkswagen bond yielding 2.5% more than gilts post the defeat device scandal just might. (This judgment would include the exit of culpable senior management and a clear shift in corporate practices at Volkswagen.)
Environmental and social considerations tend to be quite similar for both equity and bond investors. It is when it comes to governance that there is some divergence. Factors like ownership structure and operational controls matter for both. However, when it comes to a company’s dividend policy or attitude to its credit rating, shareholder and bondholder interests can be diametrically opposed. Having said that, the interests of equity investors with a sufficiently long-term focus may be more closely aligned with bondholders in the sense that neither’s interests are best served by an overly aggressive, and ultimately unsustainable, dividend policy.
Hence our fondness as responsible bond investors for mutual structures and for companies with a regulatory requirement to maintain an investment grade credit rating. Dwr Cymru (Welsh Water) is an example of an issuer that ticks both boxes, contributing to its high score for governance on our internal ESG credit ratings system.
In fact, well over half of our credit book consists of issuers that have no publicly listed equity. This also serves to illustrate that responsible bond investing allows clients to support a different range of impact sectors from responsible equity investing, notably in areas such as education, housing, and transportation and renewable energy infrastructure.
Embedding into the investment process
A common misconception about ESG investing is that it just simply involves negative screening, i.e. excluding investments in ‘sin’ sectors, such as tobacco or armaments. But it means much more than that. It means having a thematic bias to invest in sectors whose activities create positive externalities, like wider gains for societies at large, such as renewable energy infrastructure or social housing.
Nor need the responsible approach entail any kind of limitation on the returns that are possible. With the exception of tobacco, most sectors that score poorly on ESG criteria, such as aerospace and defence, alcohol, oil and gas and automakers, tend to offer relatively unattractive yields (to say nothing of the asymmetric price risks posed by their occasional highly publicised ESG difficulties).
The reason is that they tend to be long-established companies which are highly familiar to investors (expressed less positively, they are frequently old industries falling into secular decline). They often trade at rich valuations because they offer investors some degree of diversification away from the core credit sectors of utilities, financials and telecoms.
On the other hand, many of the infrastructure-related names and housing associations to which we lend tend to be newer and less well known, hence investors require an “unfamiliarity premium” to hold them, as well as a liquidity premium given their total outstanding issuance is typically much less.
As ethical considerations become increasingly important for clients, we are likely to see a surge in demand for bond funds with a specifically responsible or sustainable focus. Companies need to respond to this evolving demand in their approach to corporate ESG or ultimately risk being shut out of debt capital markets entirely.
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.