Investor influence has long been confined to that of equity shareholders. Yet bondholders wield a lot of power. Can they harness it for positive change?
Read this article to understand:
- How bondholders can develop long-term engagement relationships with issuers
- The dynamics that are already increasing bondholders’ influence
- How developing a framework and careful selection of issuers to engage with can help maximise bondholders’ impact
Barclays had long been unresponsive and a laggard on climate change, being one of the largest financers of fossil fuel projects globally.
As both bondholders and shareholders, we engaged directly with the bank as part of a group of investors pushing for change, calling for it to put in place a robust and comprehensive climate strategy, develop a house view on aligning to the goals of the Paris Agreement and a transition pathway for each sector, reduce its exposure to extreme fossil fuels, and build internal capacity to manage and monitor its climate impacts. We also shared guidance on how it could approach the topic, including a ShareAction resolution, at its AGM.
Barclays responded with market-leading ambition – to be the first bank globally to achieve net-zero emissions in all of its financing activities by 2050. This was approved at the May 2021 AGM, where Barclays’ strengthened climate policy won 99.9 per cent support. We see this as evidence of a cultural transformation at the bank, recognising its crucial role in supporting the climate transition.
Figure 1: Barclays’ debt/equity ratio for the three months ending September 30, 2021 was 5.32
Source: Macrotrends, as of January 12, 20221
This shows that, while investor influence has long been confined to equity shareholders, bondholders can also wield a lot of power.
The significant untapped influence of creditors is becoming more widely acknowledged by key stakeholders
Investor influence has traditionally been viewed through the narrow prism of mechanisms to hold management teams and boards to account, namely shareholders’ voting rights and legal rights to approve capital raising or broader strategic issues. However, times are changing, and the significant untapped influence of creditors is becoming more widely acknowledged by key stakeholders.
Of the $12.1 trillion raised in capital markets by companies in 2021, $5.5 trillion was via bond issuance, almost four times the amount of equity capital ($1.4 billion).2 The trend should continue as companies take advantage of the (still) low-interest-rate environment to optimise their capital structures.
“You can access and engage with a lot of companies in fixed income that you cannot access in equities,” says Marcel Borelli, executive director and head of fixed income fund selection at JP Morgan International. “You have a larger universe of companies to work with. In the climate transition, a lot of those companies are brown, and they are the ones that need finance to change. I think credit can be at the forefront of the engagement conversation.”
There are a number of strategic long-term issues investors have concerns about
This phenomenon is particularly pronounced in some sectors. “Airlines, which raise significantly more debt than equity, issued a record amount of debt over the last 18 months, coming to the market to try to secure their survival,” says Mirza Baig, global head of ESG investments at Aviva Investors. “There are a number of strategic long-term issues investors have concerns about, namely around climate, employee relations and how airlines managed contract renegotiations during lockdowns, on which investors had an opportunity to press for change.”
Contrary to common belief, bondholders also have similar time horizons to long-term shareholders. Not only are companies issuing bonds with longer and longer maturities, but even short-term bond deals also tend to be rolled over.3
“If you look at the US pharma company Eli Lilly, it issued a 40-year bond recently, so our engagement as creditors would be identical to the approach we take and areas we focus on as equity shareholders,” says Baig. “Even for companies issuing three or five-year maturities, it doesn't mean debtholders’ time horizons are restricted to that period because companies will have to issue at regular cycles. They will come back to the market, either to refinance maturing debt or issue more debt for growth, so their relationship with the credit market is a permanent one.”
And while the extent of engagement activity is not yet commensurate with this potential, things are changing.
Why bondholder engagement will increasingly affect pricing
“Over the last two years, the UK Stewardship Code has made much more explicit reference to the responsibilities of bondholders, with respect to monitoring and engaging issuers,” says Baig. “We've also seen the Investment Association initiate a bondholder engagement working group, looking at capacity and trying to define an appropriate framework for engagement.”
Lessons have been learned from shareholder engagement
Within asset managers themselves, other changes are afoot. Firstly, rather than leaving engagement in the hands of dedicated ESG teams alone, investment teams – credit analysts and portfolio managers – are increasingly engaging directly with companies and doing it well. Lessons have been learned from shareholder engagement, which saw its influence increase significantly once equity portfolio managers joined the discussions with the boards and senior leadership teams of investee companies.
“It's also important for companies to understand these engagement asks have consequences and will fundamentally flow through to how their investors allocate capital, their risk appetite, and their pricing points,” says Baig. “We're hopeful that as more credit portfolio managers get involved in this process, bond issuers will start viewing the dialogue in a very similar light.”
The impact on credit spreads is already being felt. In a recent MSCI study looking at bond issuance between 2014 and 2020 (normalised for credit risk), companies in the top third of ESG scores outperformed the bottom third by 5.5 per cent. As more and more investors acknowledge this and integrate ESG indicators into their price points, companies with improved ESG scores and performance are likely to benefit from a lower cost of capital.4
We are beginning to see the change and it is exciting
“Companies may raise equity once every 20 years; some companies are coming to the debt markets every six months,” says James Purcell, group head of ESG, sustainable and impact investing at Quintet Private Bank. “That window for dialogue is an untapped opportunity for engagement, and we are starting to see funds stepping into that space with explicit mandates. They are talking about the ability to generate alpha through sustainable improvement, and the idea is that this will reduce risk for investee companies, and hopefully tighten credit spreads. We are beginning to see the change and it is exciting.”
Baig says two other changes are underway. One is that dialogue will extend beyond the normal issuance cycle, to take place regularly and allow bond investors to discuss strategic issues with companies on an ongoing basis. The other is capacity building at a corporate level. Some issuers are not accustomed to engaging with creditors and, in the private space, they have underdeveloped investor relations teams. “That absolutely needs to change if we are going to make this dialogue more impactful and systematic,” he says.
Those changes will also answer a key challenge of engagement today, which is most bondholders do not have a contact point at companies. Direct relationships can be built using credit analysts’ access to company CFOs as investment teams get more involved, and thanks to larger, more credit-aware investor relations teams.
Developing an engagement framework
Given how oversubscribed certain bond deals are, companies might not feel the need to respond to a single investor. This is why collaborative engagement is critical.
We could make a large step forward through collective engagement
“Typically, when deals come to market, they are heavily oversubscribed, so the idea any individual investor could have outsized influence is overoptimistic,” says Purcell. “We could make a large step forward through collective engagement. If companies need capital, you could potentially put them together with a large body of investors with size and influence.”
“What is most powerful is when equity investors engage alongside bond investors. If they do that, they can bring more money to the table and have a bigger voice,” adds Hortense Bioy, global director of sustainability research at Morningstar.
“It's all in the design of the engagement framework, the specific questions investors should ask depending on the type of company, and timeframes for change,” says Emily McDonald, credit investment director at Aviva Investors. “Once you've defined the process, it gives you reference points to monitor to see whether it's successful.”
As a component of ESG integration, the results of well-designed engagement help strengthen the investment team’s conviction when making decisions. For instance, in early 2021, our liquidity portfolio managers were considering taking exposure to commercial paper (CP) issued by a large European bank. (While CP is a short-term instrument, investments are most often long-term in nature due to the perpetual rolling over at maturity typical in the CP market, hence the importance of engagement.) (See Credit: The long and short of ESG investing).5
When the FCA announced in March 2021 an anti-money-laundering case against the bank and given the materiality of governance to the banking sector, we initiated engagement with the chair of the institution, raising our concerns around the case and its controls and policies. The discussion revealed a lack of proactive response to our governance concerns, which led directly to the decision not to invest.
A well-defined framework will also need to be focused on a limited number of key asks depending on the theme – for example, climate, biodiversity, or social responsibility. For instance, for climate, choosing whether to focus on science-based targets or carbon metrics first requires a fundamental understanding of how a company or sector can best achieve meaningful impact.
We need to understand what the goals of the engagement programme are
“We like to see an escalation strategy,” adds Bioy. “We need to understand what the goals of the engagement programme are, which specific issues have been identified and what outcomes are expected. Also, the engagement must be timebound. How much time is given to a company to address the issue? If the issue isn’t managed as expected, what is the escalation strategy?”
Given the number of issuers in the credit universe, investors also need to prioritise the companies to engage with to avoid spreading themselves too thinly.
Private versus public
Because so many companies are privately owned – around 20 per cent of investment-grade debt and 60 per cent of high yield – credit investors have an opportunity to influence companies well outside the reach of shareholders.
“If they are going to cover their entire portfolios, credit fund managers need to go out on their own as well; they cannot hide behind their equity colleagues. That is a huge impact they can have,” says Baig.
Engagement with private companies can have a bigger impact versus public blue-chip companies
In addition, because private companies are at an earlier stage of their ESG journey, engagement can have a bigger impact versus public blue-chip companies with established ESG policies and transparent disclosures.
“The starting point is much lower with private companies, but they may also be more dependent on financing than a blue-chip company, so an investor can have a bigger opportunity to influence them,” says McDonald.
“With high yield versus investment grade, it's a similar argument because there is a larger proportion of private companies,” she adds. “Again, you can influence them a lot more; if they've got a lower credit rating, their need for financing is more acute and they are going to be more sensitive to the cost of borrowing.”
Baig agrees, explaining that private companies have underdeveloped investor relations departments and less capacity and cultural awareness of engagement. As such, investors are starting from a lower base but with significantly greater scope to influence and impact the risk profile of the issuer.
“You could argue high-yield engagement is more challenging, but there are bigger fruits on offer, and it is more valuable to us as investors,” he says.
High-yield engagement is more challenging, but there are bigger fruits on offer
In 2021, one of our credit analysts spotted an opportunity to invest in a high-yield issuer in the cosmetics sector. The firm had a low ESG rating but had recently appointed a new CEO, which the credit analyst viewed as a prime opportunity to engage with a company about to embark on an ESG transition. The ESG analyst was able to provide further insight, which gave the credit analyst the ability to question the management team meaningfully, and get to know them.
The company had little experience of such conversations with investors. As a result of the engagement, the company’s management team sees the benefit of hearing our suggestions and wants the firm to be viewed as a credible (and creditworthy) issuer. It is keen to hear our perspectives on what investors are looking for from an ESG perspective, giving us the opportunity to influence and work with the company to improve its sustainability credentials.
Sovereigns: The next frontier
Beyond public and private companies, bond investors are turning their attention to sovereign issuers, which Baig describes as the next frontier of engagement.
Sovereign issuers come to investors and are willing to engage in a dialogue with us almost in an advisory capacity
“It's the untouched asset class to some extent, and the reason why investors had been hesitant to focus on this area is because there's a tendency to conflate leverage with influence,” he says. “Leverage is dramatically diminished with sovereign issuers, as they typically issue highly oversubscribed debt and are less dependent on international capital markets. But that is different to whether you have an influence.
“We found that sovereign issuers, particularly in emerging markets and on thematic issues, want to better understand international investors and are looking for opportunities to showcase their credentials and potentially lower their cost of capital. They come to investors and are willing to engage in a dialogue with us almost in an advisory capacity,” he adds.
This creates a very different dynamic where, instead of entering a discussion with a series of demands, bondholders share best practice and advise finance ministries and central banks on relevant initiatives taking place elsewhere they can take into consideration in their own policy evolution.
“We trialled sovereign engagement with countries such as Brazil and Indonesia in 2019, and it quickly escalated to engaging with senior members of government, including the Vice President of the Brazilian Parliament, which was seen as a proof of concept,” says Baig. “We followed that up in 2021 through a broader engagement programme with 21 sovereign issuers, with a tilt towards climate leading up to COP26. We were pleasantly surprised with the level of uptake, both on their willingness to engage, but also several incidents where they embraced some of our recommendations and explicitly attributed them to our discussions. Engagement does work and we will look to cover a broader set of topics in 2022.” (See Lean on me: How can bond investors influence government climate action?)6