Special Report: How ESG Is Changing Fixed Income Investing
In just the last two years alone, we’ve witnessed climate change bear down with increasing intensity. We’ve seen corporations acknowledge a lack of diversity in their top leadership positions. And, of course, we saw social issues dominate public consciousness in the U.S. in 2020, as racial injustice challenged the essence of the country’s foundation, and the COVID-19 pandemic shone a new light on systemic inequities.
The impacts of these events – and others both ongoing and newly developing across the world – emphasize the growing urgency that ESG issues pose for institutional investors and other members of the financial industry.
This special report examines how ESG factors are changing the landscape in fixed income investing, and how institutional investors and security issuers are navigating the new terrain.
Creating an Effective ESG Strategy in Fixed Income
Today, institutional investors well understand that the integration of ESG risks and opportunities is no longer optional, but crucial to their entire investment process. Of course, creating an effective, cohesive ESG strategy that can adapt quickly as new developments occur is vital for both equities and securities – but achieving this can be more difficult for the latter, as many investors are learning.
To illuminate the challenges and opportunities that evolving ESG needs are creating in fixed income investing, we spoke with Armelle de Vienne, Vice President and U.S. Team Lead for ESG at PGIM Fixed Income, the global asset management firm that’s a recognized leader in providing solutions for institutional investors to achieve their ESG and sustainability objectives. The firm is the dedicated fixed asset manager of PGIM, the investment management business of Prudential Financial, Inc. in the U.S. (which is not affiliated with Prudential plc in the U.K.). With $964 billion in global AUM as of September 30, 2021, PGIM Fixed Income currently serves more than 900 clients worldwide with a full range of global, U.S. European, and Asian funds, supported by nine international offices (with the most recent expansion in Hong Kong).
Why does ESG matter to Asia (ex-Japan) Investors?
Armelle de Vienne: Although Asian institutional investors have lagged behind European and U.S. counterparts in incorporating ESG factors into their investment process, we have seen growing awareness and appetite amongst Asian asset owners to prioritize ESG analysis, integration and climate change related issues into investment decisions.
There are certainly a number of reasons for that, some of which are because of a greater recent sensitization to these issues: firstly, COVID-19 certainly helped put the focus on corporate resilience, social and broader sustainability issues. Similar to other regions, conversations of a ‘green recovery’ are underway and countries such as China who have pledged carbon neutrality by 2060 or South Korea, which committed to ending public funding of coal-fired power plants have signaled shifts in policy. Secondly, 2020 saw a record number of climate disasters in Asia-Pacific, from flooding to droughts and other extreme weather events that affected tens of millions of vulnerable peoples. Thus, the urgency of these issues is constantly being reiterated. In fact, since 2020 we’ve seen record inflows into ESG funds from Asian investors, especially Chinese and South Korean. Further supporting this trend, the Chinese government recently issued guidelines for public companies on how to disclose risks posed by ESG factors.
I believe that with increasing transparency and consistency of disclosure, policy shifts, heightened sensitivity to ESG issues, and perhaps a few key players leading the way, the Asian market is ripe for significant future growth in ESG funds.
As a fixed income investor, how does your approach to ESG differ from the one taken by most equity investors?
It differs in four ways. One is due to the greater complexity. Not only does fixed income have more asset classes, but you also can’t look at sovereigns, munis or securitized products in the same way as you look at corporates when assessing ESG concerns. For sovereigns, for example, you also have to think about education levels, economic freedom, life expectancy, and things like that. For secure debt, you often think about how the issues impact the collateral more than the issuer. So fixed income is just more complex from an ESG perspective.
Secondly, ESG in fixed income is more about protection against downside risk in a negative scenario, whereas equities can capture more potential upside.
Third, we rate materiality on ESG topics differently, especially involving intangibles. If you look at the S&P today, 90% of its value is based on intangible assets. Equity investors place more emphasis on the materiality of ESG topics in how they impact intangibles like branding, because people will trade on that sentiment premium. Credit investors, however, put more emphasis on those ESG topics that impact tangible assets and cash flows.
And then the fourth way it differs involves engagement. Equity investors buy shares and essentially get a ticket to vote at the AGM, and most engagements between corporates and shareholders are really just temperature checks to ensure they’ll vote in favor with management. For the credit investor, we don’t have the same kind of leverage. Instead, it’s a contractual relationship – once we buy the bond, and the issuer pays its principal and coupon on time, we have little leverage. So engagement means keeping issuers informed on some of the things we’d like to see happen or else we might need to divest.
How has institutional investor demand changed over the last one to two years? And are you seeing any regional differences?
It’s no surprise that we’re seeing growing demand from institutional investors. A case in point is that PGIM Fixed Income launched its ESG team a little over a year ago, and we’ve been growing steadily. And we’re not the only ones; last summer PwC announced that they’re boosting head count by 100,000 employees over the next five years to meet the demand of ESG advisory services. On the institutional investor side, PRI got 88 new asset owner signatories from 2020 to 2021, which translates to roughly $3 trillion in AUM.
Naturally, we’re seeing increased demand from Europe because of SFDR regulations. People are wondering if Article 8 Funds will essentially become mainstream in Europe, and whether non-ESG or Article 6 Funds will even be relevant. I believe the U.S. is turning a corner. Anecdotally, I can say that we’re certainly getting a lot more ESG questions from clients and potential clients – and the sophistication of those questions has improved dramatically. Even clients who aren’t yet looking to allocate to ESG strategies still want to know how we’re incorporating ESG risk.
More generally speaking, we’re also seeing the growth of sustainable funds in the U.S. According to statistics published by Morningstar, they totaled more than $304 billion as of June 2021, a nearly 92% increase from the $159 billion one year before. Additionally, U.S. sustainable fixed income funds set a record of net inflows in one quarter of $2.7 billion.
We’re also starting to see some regulatory tailwinds, like the labor department’s acknowledgement that ESG topics are material and issues such as climate change should be incorporated into financial analysis. That is huge for providers of 401(k) and 403(b) plans, who were hesitant to integrate ESG under the last administration. Last, the SEC just hired their first ever senior policy advisor for climate change and ESG. Signals like these are showing the increased focus.
The E, S, or G: Which is more relevant for fixed income?
The G is all encompassing and has been integrated for the longest period of time. It’s also more black and white. You can’t put a price on bad management. You don’t want to touch it, so you’re not going to invest. With E and S, however, there are more shades of grey. It’s about how much risk are you willing to take, and will you get compensated for that risk? You may choose to not invest or to underweight because the risk is too high, but you must put a price on that risk.
That said, there really haven’t been sufficient disclosures to properly assess the risk and impact of the E and the S – though we’re getting there with the E. We’re performing more formal, sophisticated analyses on potential environmental impacts and these are starting to get priced in.
Can you explain the PGIM Fixed Income approach to ESG?
We look at ESG in two categories: from the risk side and the impact perspective. ESG risk is integrated in all our strategies, including those that are traditional or non-ESG. If we believe the ESG issues are financially material, why wouldn’t we incorporate that research into traditional strategies? We wouldn’t deprive those clients of that information. Our ESG-labeled strategies on the other hand go beyond that and are constructed only using issuers that are having a positive environmental and/or social impact, with their negative impacts mitigated or minimized. To determine this, we’ve developed a proprietary ESG Impact Rating that uses a 0 to 100 scale, with 100 being the best.
Our credit analysts assign their issuers a score in terms of absolute impact, not on a relative basis. It comes down to, are the issuer’s product, services and operations providing a net positive to the environment or society, or net negative? Assigning these scores allow us to tailor strategies for client needs. A client might say, “We don’t want to have issuers that have a score under a 50,” for example, and we’re able to accommodate that.
How is PGIM Fixed Income’s ESG strategy different from that of other fixed income managers?
There are two ways. One is our use of an absolute basis in scoring, as I just described. Historically, most managers use a relative basis that you see in many best-in-class strategies. They can have, say, an oil and gas company with a negative impact included in a strategy, simply because it’s the best in its industry. Using absolute scale is more difficult and challenging, but you can also argue that we’re having a net positive effect on the environment and society. We’re starting to see more managers and third-party data providers look at absolute impact, and I think that shift is going to continue – partly because EU regulation is more aligned to absolute impact.
The other aspect is unique to PGIM Fixed Income, and that’s the fact that we’ve integrated ESG into our credit process from the get-go. Our credit team has over a hundred analysts, and they are responsible for ESG research. It’s fully integrated into their own risk assessments. That’s unique because most managers have long preferred to keep their ESG team separate and just overlay their research into the process later. Now many are realizing that ESG needs to be integrated from the beginning.
How does PGIM Fixed Income integrate ESG factors into your credit analysis?
We perform fundamental bottom-up analysis that’s very issuer-specific, and ESG is no different. So credit analysts will look at ESG from this risk perspective, and then integrate it into their overall risk and relative value assessments. They will source ESG information from sustainability reports, annual reports, third-party data providers, as well as NGO analyses and government reports. And they’ll often supplement that information through direct engagement with the issuer. They will assess material ESG risks and opportunities, which will vary by sector, business model, and are issuer-specific, and incorporate it into their overall risk assessment. Our portfolio managers will consider all these ESG risks and opportunities when assessing risk-reward, i.e. the overall attractiveness of potential investments.
How do you view and assess green and sustainably linked bonds?
For GSS bonds, we look at credibility and additionality. On the credibility side, how do the bond’s proceeds fit into the issuer’s overall ESG strategy? Is it aligned, or opportunistic? We have a number of criteria in terms of tracking the use of proceeds, including reporting, timelines, and second party opinions. But it really comes down to this question: Is the issuer serious about affecting change?
For additionality, we want to determine how transformative these projects really are. If a coal producer is looking to use LED light bulbs, that’s obviously not as additional or transformative as saying, “We’re going to shut down the coal facility and now invest in renewable energy instead.”
With GSS bonds, we can assign an ESG Impact Rating to not only the issuer, but also to the actual instrument – and that can result in an uplift their score. Let’s say there’s an issuer that gets 40 on our ESG Impact Rating, but they have a bond that we view as high quality. If we assign that bond a 20-point uplift, that gives them a new score of 60 – and now that specific bond instrument may qualify for certain ESG strategies while the issuer’s general bonds may not.
Which will prevail: economics or idealism?
What’s to say that idealism is the opposite of economics? Historically, we’ve used certain metrics to measure economic success that are probably incomplete. GDP is the most obvious one. But what are we really trying to measure? I would argue that it’s the ultimate well-being of society. Money certainly enables that, but the wealthiest countries aren’t necessarily the ones with the lowest maternal mortality rates, best personal freedoms, or lowest discrimination. So we need to shift our metrics and think about a more holistic picture. There is a cartoon from the New Yorker that comes to mind. Its caption reads, “Yes, the planet got destroyed. But for a beautiful moment in time we created a lot of value for shareholders.” What’s the point of economic prosperity if we’re not going to be around to enjoy it?
Green Bond Impact Ratings: Turning Brown into Green
Since the World Bank issued the first green bond in 2008, they have soared in popularity; the total global market for green bonds topped $496 billion in first half of 2021. While these fixed income instruments are all ostensibly designed to support climate-related or environmental projects, not all green bonds are equal. Some carry a much greater ESG impact than others. Sadly, there are no standardized metrics or criteria that establish just how “green” a green bond must be.
That’s problematic, as issuers have strong incentives to label their bonds as “green” (including larger coverage ratios, narrower spread concessions, and better performance in the secondary market). While they agree to adhere to the voluntary guidelines that aim to promote market transparency and integrity, there is no standardized measure for this compliance nor any penalties for non-compliance.
This lack of clear, comparable metrics makes it difficult to assess a green bond (or appropriately gauge its true “greenium” value), creating challenges for both ethical issuers and institutional investors.
PGIM Fixed Income’s Green Bond Impact Ratings
To address this problem, PGIM Fixed Income introduced its proprietary Green Bond Impact Ratings in 2020. This framework is now a key tool in the firm’s security selection process, as itallows analysts to assess the issuer’s credibility at both the security and issuer level, and the bond’s additionality in terms of its incremental positive impact on the environment (and eplacing “brown” assets or activities with “green” ones for the issuer or its industry).
As with the ESG Impact Rating discussed in chapter 2, these separate assessments can be combined, possibly resulting in an uplifted score that makes an individual green bond eligible for certain ESG strategies – even if the issuer remains ineligible.
PGIM Fixed Income analysts can also review an instrument’s Green Bond Impact Ratings after issuance and revise its score in light of actual activity. This approach allows ESG strategies to invest in more truly impactful green bonds from issuers that, again, would otherwise be ineligible for inclusion.
The ratings use three impact levels
The Green Bond Impact Rating has three scoring levels:
- High Impact: Projects financed by green bond proceeds are core to transforming an issuer’s business model and operations from brown to green, with green economic activities expected to replace brown activities.
- Medium Impact: Projects financed by green bond proceeds are either non-core to the issuer’s business or are seen as an addition to core brown activities.
- Low Impact: A green bond with low credibility, proceeds slated towards a relatively unambitious project, or a combination of both characteristics.
The overall impact assessment allows PGIM Fixed Income’s analysts to determine if a given bond’s ESG Impact Rating deserves an uplift compared to the issuer’s ESG Impact Rating and, if so, to what extent.
Many of the High Impact bonds will likely be issued by relatively “brown” issuers, as they have the most room to transform via credible, ambitious plans and need a way to finance the transition.
As investors await improved standards to enhance issuers’ accountability on their green bond pledges, the Green Bond Impact Rating assessment provides a framework for evaluating the credibility and additionality of these securities. For institutional investors seeking to make an environmental impact through ESG-oriented investing, this assessment is a vital component of the security selection process.
PGIM Fixed Income’s Growth in Asia Pacific
PGIM Fixed Income opened its Hong Kong office in 2020, expanding its presence in the Asia Pacific region – and adding a ninth office to those already established in Singapore, Tokyo, London, and Newark, New Jersey. We asked Helen Chang, CFA, Managing Director and Head of Asia Pacific ex Japan Client Advisory for PGIM Fixed Income, to offer more details about the asset management firm’s recent expansion in Asia Pacific.
How does PGIM Fixed Income’s focus on strengthening its presence in the Asia Pacific region fit into its larger business strategy?
Helen Chang: Asia Pacific remains an important part of PGIM Fixed Income’s overall growth story. We have continued to adopt a long-term strategic plan to focus on providing dedicated investment solutions for our clients in the region. We are pleased to see the strengthening partnership that we have built with existing clients while at the same time developing trusted relationships with prospective clients, including sovereign wealth funds, central banks, pension funds, insurance companies and family offices.
Notwithstanding the market challenges as a result of the pandemic and interest rate outlook, we have continued to work very closely with clients in coming up with an approach that leverages on our fundamental credit research across our suite of fixed income strategies while at the same time helping them understand their investment risk. We will continue to stay focused in customizing investment solutions that deliver long term benefits for our clients.
What is PGIM Fixed Income’s vision for client service?
Our vision is to be widely regarded as one of the premier active global fixed income managers in the world. PGIM Fixed Income’s capabilities and expertise extend across a wide range of traditional and non-traditional fixed income sectors globally. As a group, we specialize in managing credit-related portfolios including investment grade and high yield corporate bonds (global, European and US), emerging markets debt, structured products and bank loans, and multi-sector portfolios. We also manage specialized products including hedge fund strategies and collateralized loan obligations.
What specific regions in Asia Pacific are you now serving clients in?
While we have established presence in the region for many years, we have continued to build our client advisory team by opening an office in Hong Kong a year ago. To further augment our coverage with asset owners in the region, we have been adding resources with the hiring of experienced client advisors and client servicing professionals with local language skills and cultural understanding of business best practices. Hong Kong is well positioned to service our clients in Mainland China, Hong Kong, Taiwan, Korea, Singapore, Thailand, Indonesia and other parts of the region.
Learn more about fixed income investing in global markets.
Helen Chang CFA
Head of Asia Pacific ex Japan
Client Advisory Group
PGIM Fixed Income
T: + 852 3769 8283
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A Closer Look at ESG Impact Ratings
PGIM Fixed Income considers integrating relevant ESG factors into the investment process as part of its ultimate fiduciary duty: searching for the highest risk-adjusted returns for clients. The firm assesses ESG factors for all issuers that it covers, across all asset classes. To improve these assessments and help clients invest according to their ESG/sustainability preferences, PGIM Fixed Income developed a proprietary tool in 2020 called ESG Impact Ratings.
This tool focuses on the negative and positive impacts that issuers have on the environment and society, irrespective of their credit materiality today. It provides analysts and portfolio managers with a holistic view and forward-looking perspective on the long-term sustainability of an issuer’s business – and helps identify those that are actively increasing their positive impacts and reducing their adverse impacts. This identification is particularly important for the portfolio managers of ESG-focused clients, who can use the ratings to determine the eligibility of an issuer’s debt for investment.
Institutional investors can use the ESG Impact Ratings to tilt their portfolios toward investments with a higher ESG impact assessment relative to peers.
Understanding the ESG Impact Ratings methodology
PGIM Fixed Income’s analyst teams (including corporate, sovereign, securitized credit, municipal) take ESG risks and opportunities into account as part of their analysis – as well as adverse impacts and positive contributions to society and environment. The analysts then parse these ESG factors into those that they believe to be:
- Credit material, focusing on economic value; and
- Impactful on the environment and society, whether those impacts are immediately credit material or not.
Analysts’ assessment of credit material ESG factors are key inputs to their credit ratings, and their assessment of impact factors ultimately determines an issuer’s ESG Impact Rating.
Over time, ESG factors that are initially not deemed credit material can become so, as seen with issues such as diversity and inclusion, community relations, and plastic pollution. Similarly, other factors that are not credit material today – such as supply chain due diligence, deforestation, and other bio-diversity issues – may become material soon.
Importantly, the ESG Impact Rating assessment is distinct from PGIM Fixed Income’s assessment of the risk that ESG events could have on the financial and economic value of its clients’ investments.
Understanding the 100-point scale
The firm’s analysts assign an ESG rating to an issuer or issue using a 100-point scale, in 5-point increments with 0 as the lowest and 100 as the highest ESG Impact Rating. (See Figure 1). In assigning a rating, the analysts review information provided by the issuer, third-party research providers, and/or alternative data sources (e.g., NGO analyses, governmental and inter-governmental studies, etc.).
In the process of assigning an ESG Impact Rating, the environmental and social issues the analysts consider will vary by asset class, industry, individual issuer and/or issue. In general, however, they can include:
- Energy use/performance; greenhouse gas (GHG) emissions
- Waste management/hazardous materials; pollution
- Water consumption and pollution; air pollution; ecosystems
- Human rights; employee rights/ labor rights; health & safety; community relations
- Business conduct
The rating process boosts engagement
The ESG Impact Ratings facilitate engagement between issuers and PGIM Fixed Income’s analysts. This communication provides issuers with tangible feedback about ESG concerns – including insights into how they compare to industry peers and how markets perceive their ESG initiatives.
The interaction can also inform the analysts’ investment research. PGIM Fixed Income may assess the issuer’s plans to address material ESG issues, factoring that qualitative element into both fundamental credit ratings (which drive relative value assessments) and the ESG Impact Ratings.
Given the importance of this engagement, issuers will approach PGIM Fixed Income to request feedback on their ESG status and improvement initiatives.