Driving the ESG agenda through fixed income

This is critical for driving the environmental, social and governance agenda because, ultimately, to create longstanding and holistic change, fixed income must play a leading role.

This is particularly pertinent to pension funds, with the average UK scheme allocating almost a third (32 per cent) of its portfolio to fixed income assets, according to data from the Investment Association.

Research by Octopus Renewables also revealed that 92 per cent of schemes stated that they plan to increase their allocation to ESG assets such as renewables. 

We see greater opportunity for positive change through impact-related bond strategies, where issuers are individually selected and there is the transparency available to measure the impact they are having

Active versus passive

Traditionally, ESG investing was limited to simply screening out the ‘bad bits’ of the investment universe. But any passive manager can do this, so how can active managers add value within this space? The answer: participate in engagement.

With fixed income, there is a chance to engage as a condition of ongoing issuance, and through this there is the opportunity for ongoing dialogue.

While bondholders do not have the voting rights of their shareholder peers, they do have the ability to support, or withdraw support, from new issuance — with the potential to drive up borrowing costs.

Layer on top of this active managers with the ability to go both long and short, and you have the carrot and the stick at your disposal to push for positive change.

Shorting brown debt

One example is Saudi Arabia, which our ESG proprietary framework had previously identified as our highest risk ESG sovereign in terms of ESG rating.

During early investor meetings, we flew the flag of ESG, but much of our feedback was dismissed. Soon after we took a sizeable active short position.

For the ensuing waves of issuance, Saudi Arabia was open to listening, wanted to engage, and ultimately wanted to learn what it could do to pursue a more progressive ESG agenda.

However, shorting for the sake of positive impact is something we are often limited in taking advantage of through our conventional funds only, versus our ESG-focused strategies. The reason being is that ESG-focused investors tend to be more restrictive in their portfolio construction.

For example, most ESG-focused investors would express the need for a blanket ban on tobacco.

However, it is an industry that we might like to short to push the ESG agenda forward. That said, we continue to see it as an approach where active managers can generate returns while offering the potential to drive positive change.

Looking ahead – buyer beware

According to a report from PwC, ESG funds are projected to triple in size by 2025.

Across the financial services industry, it has become a bit of an ESG ‘arms race’. As this market grows, so too will the need for investors to be able to identify those managers that greenwash or see ESG as a tick-box exercise.

Within fixed income, green bonds are one such example of ‘buyer beware’.

Perhaps it is a legitimate form of investment when it results in a project taking place that otherwise never would have seen the light of day. Unfortunately, it feels like a lot of green bond issuance is simply being done by issuers looking to cash in on lower borrowing costs.

Instead, we see greater opportunity for positive change through impact-related bond strategies, where issuers are individually selected and there is the transparency available to measure the impact they are having.

Many pension funds are beginning to get a better grasp of incorporating ESG considerations into their investment practices, requiring external managers to demonstrate competence, exercise stewardship and evidence action on climate, and we expect this to continue. 

This should be further supported with the introduction of the Sustainable Finance Disclosure Regulation, with the regulator aiming to help investors easily identify instances of greenwashing.

For pension funds in particular, it will increasingly be at front and centre of their investment decisions following the introduction of the Pension Schemes Act 2021, which enables the introduction of rules to push trustees to measure the impact of their schemes on climate change.

Mark Dowding is chief investment officer at BlueBay Asset Management