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WHY ASSESSING ESG FACTORS CAN REDUCE CREDIT RISK
Scott Freedman
Fixed-income portfolio manager Newton Investment Management
When it comes to assessing the risks around fixed income invest- ments, environmental, social and governance (ESG) factors have traditionally been viewed through the rear-view mirror, when something has already gone wrong. We believe it makes sense to employ a forward-looking assessment of ESG-related credit risks, to help reduce the chance of potential future hazards.
Having integrated ESG considerations into credit analysis for sev- eral years, we have always believed that considering the materiality and impact of ESG factors on companies and countries is crucial to risk assessment. In our view, it results in better decision mak- ing, and should, if done with diligence and consistency, result in superior risk-adjusted returns because ESG factors can have a material impact on credit risk and, therefore, performance.
In our engagement with companies, the environmental, or ‘E’, factor often comes to the fore, with conversation increasingly focused on trying to limit the environmental impact of climate change. In time, ‘S’ and ‘G’ factors may also become more regu- larly considered in a more explicit manner (at Newton they already form an important part of our ESG assessment for companies and countries). However, in fixed-income investing, it is probably fair to say that ‘E’ factors are the most tangible to perceive and quantify – although this is not to suggest that measurement is easy.
Fixed income and equity: how the ESG approach differs Another question we are often asked is how an ESG engagement approach differs between fixed income and equities, given that bondholders do not get to vote on corporate policy. Owing to the risk asymmetry between bonds and equities, downside risk miti- gation is more important for fixed income (bonds have limited upside but similar downside risk to equities). Generally speaking, a company with a strong ESG profile should benefit equity inves- tors and bondholders; differences will be driven by management’s financial policies and decisions about whether to prioritise debt- holders or shareholders. Another key difference is that bondhold- ers have a variety of relevant ESG-themed areas available for
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February 2020 portfolio institutional roundtable: ESG and fixed income
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