Reprinted from Medium.com
By Francis Menassa — Founder of JAR Capital, an independent wealth and asset management firm based in St. James’s, London.
Over the last two years, investment in sustainable fixed-income assets has increased significantly. Indeed, according to a recent report from the Global Sustainable Investment Alliance, sustainable fixed-income investing now accounts for more than a third of all responsible investing – an increase of 34% in just 24 months.
Of course, interest in sustainable investing should come as no surprise; evidence of worsening climate conditions and shifting attitudes towards the environment are key drivers of this trend. However, in the case of fixed-income assets, a new European Union law requiring large companies to disclose information about the way they manage social and environmental challenges is also having a big impact on the sector.
In the past, incorporating environmental, social, and governance (ESG) factors into fixed-income investment analysis was challenging, particularly in the high-yield space. Unlike in equities, there were no ESG credit ratings, as fixed-income ratings agencies had little access to ESG information. There were also no sustainability indices which investors could benchmark performance against. In addition, the debt issuers themselves were unprepared for any ESG concerns from investors during the fundraising process.
However, the European Union’s 2014 Non-Financial Reporting Directive, which was implemented in late 2017 and requires companies in the EU to disclose non-financial and diversity information is changing things. Designed to help investors, consumers, policy makers and other stakeholders evaluate the non-financial performance of large companies, while also encouraging companies to develop a responsible approach to business, this law requires companies to increase transparency when issuing debt.
Already, there are signs that the EU Directive is making an impact, even if progress is slow. As a result of the new Directive, many companies are now working hard to improve corporate governance and enhance their communication, while also using their resources more efficiently. As a consequence, the reduction in legal, environmental, and reputational risk factors is creating more opportunities for sustainable fixed-income investment.
Sustainable fixed-income experts
At JAR Capital, our portfolio managers are highly experienced in the sustainable fixed-income space. For us, assessing environmental, social and corporate governance factors is an integral part of the investment decision-making process. As pioneers in sustainable fixed-income investing, we have developed our own ratings system in conjunction with ISS-oekom, one of the largest independent rating agencies in the sustainable investing space. In addition, we employ ESG experts to enhance our investment analysis.
The European car industry is one example of where we have added value in the sustainable fixed-income space. Many companies within this industry had no published ESG data and there was little transparency in their operational structure, and this was limiting their finance options. Yet our research told us that most complied with sustainable standards, and we offered guidance on sustainability standards to help improve their ESG ratings.
We believe that sustainable high-yield fixed income funds have the potential to effect positive change while generating improved returns. Despite the higher-risk nature of sustainable high-yield fixed income investing, we have had no defaults in any of our funds to date. In the high-yield space, complex analysis of companies’ opaque debt structures is required, and reporting inconsistencies and gaps in accessible information can make it difficult to compare companies. This can result in mispriced risk. Enron, Worldcom, and Parmalat are examples of how things can go wrong. However, in the case of Parmalat, we chose not to invest as our analysis told us that there were significant shortcomings in the company’s debt structure.
New standards will drive further growth
Today, we are seeing more unique approaches to sustainable fixed-income investing. Thanks to advances in technology, there are more sophisticated methods of data collection and interpretation.
There is also a range of benchmarks to draw from as well as highly-regarded sustainability standards, both private and governmental. For example, in March 2019, the European Parliament introduced rules under its Sustainable Finance Action Plan that require asset managers to use a common reporting standard to disclose how they consider ESG factors in an effort to prevent them from ‘greenwashing.’ Additionally, the FNG Label, established for sustainable mutual funds, provides a transparent standard for mutual funds that pursue a consistent sustainability strategy.
These major policy developments, combined with the growing awareness of the importance of sustainable investing, are presenting unique opportunities for the sustainable fixed-income sector. As a result, sustainable fixed-income investing is something that we are likely to see a lot more of in the years ahead.