Credit is an asymmetric asset class. The upside is a coupon payment and limited capital appreciation; the downside is a default to zero. For all maturities and bond types, ESG integration can play a crucial role in mitigating risk.
Liquidity investing is akin to running a series of sprints. Buy-and-maintain portfolios, on the other hand, resemble a marathon. Just as sprinters and marathon runners need different skills and face different pitfalls – stumbling for one, running out of steam for the other – short and long-term investors must manage and mitigate different sets of risks. Increasingly, these relate to environmental, social and governance (ESG) factors.
Credit is also asymmetric: as bonds or short-term instruments like commercial paper (CP) can default, the downside risks are always greater than the upside potential.
ESG is a key determinant of value creation and protection, and therefore highly relevant to liquidity and buy-and-maintain investors. Understanding non-financial aspects of a company’s performance offers vital insights into a business.
In this article, we answer seven key questions credit investors need to consider when it comes to ESG, whether they are sprinters or marathon runners.
What types of ESG risks should credit investors consider?
Short-term ESG risks are typically shocks to a company and can manifest via controversies brought on by issues like lapses in governance, misconduct, or health and safety breaches. As such, in assessing short-term risks, an understanding of the quality of governance and an ability to manage risks are paramount.
Long-term ESG risks are more often created by secular shifts in technology, regulation and consumer habits
Over the long term, ESG risks are more often created by secular shifts in technology, regulation and consumer habits. Climate change, for instance, is a quintessential example of physical, regulatory, and reputational risk that requires foresight and strategic planning. The challenge is ensuring companies in longer-duration portfolios are aligned to what the future – our societies and the environment – is likely to look like in 30 years’ time.
How are short-term ESG risks viewed in short-term investing?
ESG risks can materialise quickly and impact short-term investors perhaps even more than longer-term investors who have the luxury of time to ride out a crisis or adjust portfolios.
“Sudden scandals can create issues within portfolio management, as money market funds (MMFs), particularly triple-A rated funds, are constrained by regulators and rating agencies, which might force a divestment,” says Demi Angelaki, global liquidity portfolio manager at Aviva Investors.
“As an example, Volkswagen lost a very important funding source almost overnight following the Dieselgate scandal because its commercial paper (CP) programme became ineligible for money market portfolios. Most funds had to either sell their holdings or just let them mature and not roll them over without being able to remain invested and engage for change and remedy.
MMFs are primarily invested in financials. Governance is key
“MMFs are also primarily invested in financials,” adds Angelaki. “That’s because they usually have a high credit rating and issue more than most in the short-term market, via certificates of deposit (CD) or CP programmes. “Therefore, governance is key. Recent cases like the Archegos scandal, which highlighted governance issues in financials, stress the importance of ESG integration at all stages of investment decision making, including monitoring and engagement. We see it as a tool for downside protection as well as assurance that emerging issues can be swiftly remedied.”
How do short-term risks impact buy-and-maintain funds?
While short-term ESG risks present a major challenge to short-term investors, long-term investors have more flexibility. A sizable reduction in one-year profit – or a requirement for the company to invest to fix the issues that led to a controversy – will not necessarily have a material impact on the credit spread and returns over a longer time horizon.
“Our credit process will identify the key risks and potential for controversies within companies being considered for our buy-and-maintain portfolios. Where we believe there are material risks, we won’t invest,” says Iain Forrester, global head of buy-and-maintain credit at Aviva Investors. “Where short-term risks crystallise, a key consideration is how the business reacts and whether it is taking sensible steps to address the issues.”
What about long-term ESG risks?
While being aware of how companies manage and respond to short-term ESG risks is important, buy-and-maintain portfolios have the additional layer of a longer-term view. Forrester says several core factors come into play when looking at mandates investing for 20, 30 or even 40 years. Some are the traditional factors around an industry’s cyclicality and potential regulatory support, such as in utilities, as well as governance.
Credit and buy-and-maintain put more emphasis on long-term thematics that are reshaping the world
But understanding long-term ESG risks is an integral part of the buy-and-maintain process. “Compared to short-term portfolios, credit and buy-and-maintain in particular put more emphasis on long-term thematics that are reshaping the world – the energy transition, technology evolution, healthier living,” says Justine Vroman, senior global investment-grade portfolio manager at Aviva Investors.
“All of this shapes our thinking in finding the leaders and losers of tomorrow, and we probably give it more emphasis than you would in short-term portfolios,” Forrester adds. “The further you look into the future, the less you can rely on quantitative models of a company’s balance sheet and the more weight you have to give to qualitative assessments of how the business will react in the face of long-term trends. These are increasingly coming to bear in terms of companies’ reputational risks, and their ability to continue being profitable.”
What actions can long-term investors take to address short- and long-term ESG risks?
For long-term holdings, engaging with companies is essential to encourage them to adopt best practices that offer long-term risk protection. In cases of controversies, long-term investors can continue holding the company and engage with it to ensure issues are remedied and don’t happen again or morph into long-term problems weighing on performance.
However, if companies fail to remedy short-term risks or to adapt to long-term risks, despite engagement by their investors, divestment may be the final option. “While we might invest in a company’s 30-year bonds with an expectation of being able to hold them to maturity, we keep that assessment under review. When our view on the company changes, we will exit the position,” says Forrester.
Long-term investors can also invest in areas of the market often untouched by either short-term credit or even equity investors. “We’re able to provide firms with long-term capital and, in some cases, that debt capital will be the primary or only source of long-term capital. This includes entities such as UK housing associations, charitable foundations and universities. This gives us a very strong voice when engaging,” says Forrester.
Engagement is typically associated with long-term investing. What role do short-term investors play?
There is a common misconception that short-term investors have less influence. Indeed, the exposure and influence short-term investors have with a company can be long term. MMFs often invest in the same company for many years, which makes long-term ESG risks relevant, and creates an opportunity for meaningful engagement.
A MMF can finance a company for a long time and end up having a long-term interest in ensuring that issuer is a good citizen
“Typically, a MMF can invest up to one year and buy, for example, one-month, three-month, four-month maturities, but at the maturity of the security, the manager will generally roll it over,” says Angelaki. “A MMF that exists for ten or 15 years could be invested in an issuer, for instance a big European bank, for the entirety of that time by rolling over the maturities every three or six months. You can finance a company for a long time and end up having a long-term interest in ensuring that issuer is a good citizen.”
Climate change: What are the key risks and opportunities?
A pervasive risk such as climate change was once only considered a long-term risk. However, it is increasingly becoming a short-term one as climate shocks become more common, volatile and investor pressure grows.
For instance, a recent investor initiative that asked banks to stop funding fossil fuels is having an impact on MMFs.1 “In some labelled MMFs, like those that have an SRI label, there’s a hard limit in terms of the ESG rating accepted in the portfolio, so some banks could have been excluded if they had a low ESG rating due to their climate policies – or absence thereof,” says Angelaki.
She adds this is where money market investors can use their influence to engage with banks on the changes they want to see in terms of issues like Scope 3 emissions and social performance. Contrary to longer-term creditors, money market investors have fewer opportunities to finance transitional solution providers directly, so encouraging banks to issue more short-term debt on their part, and to support the climate transition generally, is an important way to make a difference.
Oil and gas companies are good examples of when long-term ESG risks can become short-term issues
Oil and gas companies are another good example of when long-term ESG risks can become short-term issues. These companies are under increasing pressure to pivot away from fossil fuels towards renewables, and many now have net-zero transition plans. But while this is likely to be a positive factor in addressing long-term climate risks, it creates uncertainty in the short term.
“This shift must happen to enable investors, companies and societies to go through an orderly transition, rather than chaotic, last-minute adaptations,” says Forrester. “There is an additional challenge in that we cannot know how the climate will respond to existing pressures, which creates transition risks as well.”
However, these risks offer an opportunity to identify companies that are well positioned to take advantage of not only changes in climate, but shifting technologies and consumer preferences.
“From a climate standpoint, we favour solution providers; companies that are enabling the transition toward net zero, but also transition-ready companies that are making changes today to be climate-resilient across their value chain,” says Vroman. “Thinking about digitalisation, companies operating in 5G, datacentres and semiconductors have a key role to play but it is imperative that they reduce their energy consumption. When it comes to food and beverage, some mature companies have a long road ahead to adapt their product mix to changing trends, higher physical risks and potentially stricter regulation.”
Andrea Perales Padron, ESG research analyst at Aviva Investors, illustrates the latter with the work she is conducting on biodiversity, particularly in consumer food manufacturing.
The vast reach of the large cap companies we engage with can trigger a cascade of positive changes
“We look at how companies source raw materials, which range from the implementation of regenerative agriculture to the management of water risk and deforestation exposure,” she says. “While we seek to ensure companies are adapting to climate change and building resilient supply chains, the vast reach of the large cap companies we engage with can trigger a cascade of positive changes across global food systems and farmers’ livelihoods. A company’s sound understanding of its supply chain dynamics has not only proven crucial for downside protection in recent times, but can also have an impact on reputation and brand, especially when considering changing consumer preferences towards more sustainable diets.”
Forrester adds the importance of remaining invested in utilities, which over the long term will play a central role in the energy transition.
“We accept their current position will, in many cases, reflect historic decisions on energy generation policies within their key markets,” he explains. “If you adopt an approach that prioritises a single factor, it may result in portfolios that are less diversified, or in stepping away from the firms who are ultimately integral to the energy transition.”