How to Crack the Toughest Asset Classes for ESG

Even in the most complex and opaque fixed-income markets, there are ways to integrate environmental, social, and governance considerations, according to Willis Towers Watson.

Andrey Rudakov/Bloomberg

Andrey Rudakov/Bloomberg

Environmental, social, and governance strategies abound in the equity markets — but applying ESG principles in fixed income can be a lot more complicated. With a new report, consulting firm Willis Towers Watson is seeking to help asset owners better integrate ESG into fixed-income portfolios.

The study, expected to be released Monday, breaks down the risks and rewards of ESG in four sub-sectors of fixed income: corporate credit, sovereign debt, asset-backed and securitized credit, and private debt. Out of the four, corporate credit has seen the most progress in its ESG integration, while private debt may provide the most opportunity for asset owners, according to the study.

“Fixed income is such a complex asset class; it’s not as straight-forward as equities,” Nimisha Srivastava, global head of credit at Willis Towers Watson and co-author of the report, said in an interview. “You do need to get quite specific across fixed income because, whether it’s a corporate bond or debt of a country or securitized credit instruments, those are all really different.”

Where ESG Is “Easiest”

According to the report, corporate credit’s relative success in ESG initiatives can be attributed to four factors: “the similarity in issuers and risk factors relative to equities, as many equity issuers also issue debt; greater transparency, if debt is issued by public companies; and more supporting evidence showing a positive link between ESG and corporate bond performance.”

“This is the easiest part of the fixed-income universe to think about ESG, because it has more similarities to equities than anything else,” Srivastava said. “So that means the bar is higher for what managers can do in this area.”


However, while corporate credit has made significant headwinds in ESG integration, challenges remain for the sub-sector. For instance, transparency is an issue for smaller and private companies that issue debt.

“The complexity of corporate debt (varying by maturity, ratings/quality) has made the linkage of ESG to bond performance difficult to detach, with a lack of long-term data,” Willis Towers Watson said in the report.

The best managers in the field have taken on a security- and sector-based approach, the report said. The managers that have seen the greatest success have established their own internal ESG rating systems, which help fill the “gaps” that “often exist in external ESG ratings providers,” the report said.

When assessing ESG integration of corporate bond managers, Srivastava suggests that asset owners ensure the presence of a robust framework to address risk, internal ESG rating system, wide breadth of ESG resources, and sufficient ESG training programs for fixed-income analysts and portfolio managers.

“Managers really need to have their own rating or view on ESG,” Srivastava said. “If they do that, we think they’ll naturally recognize the ESG risks.”

The “More Challenging” Asset Classes

When seeking out ESG data on sovereign debt, asset owners may find that the bulk of information is related only to governance, the report said. While data providers are starting to acquire information about the other elements of ESG practices and risks, Srivastava said the information void makes it a “more challenging” field for ESG integration.

Willis Towers Watson suggested that asset owners ensure managers focus on factors beyond governance and are tapped into countries’ low-carbon transition, which is a “key opportunity for best-in-class sovereign managers,” according to the report.

“In our view, the best-in-class approach has transitioned towards getting a better understanding of what that country is doing in terms of their plans to decarbonize, or improvements in governance,” Srivastava said.

Then there’s asset-backed and securitized credit, a “complex” market that offers less transparency and liquidity relative to other subsectors, according to the report. Like sovereign debt, asset-backed credit has an information problem, meaning that rating agencies have little to offer when it comes to ESG data.

“This is the hardest segment of the market to think about the value of ESG integration given there’s often no choice,” Srivastava said. “If you’re buying a pool of commercial mortgages, there might be 20 underlying properties in that pool. Let’s say 18 of those properties are thinking about green energy improvements. And let’s say two of those properties were using unfair labor practices. There’s not a lot you can do about it.”

In order to navigate this challenging subsector, Willis Towers Watson recommends that asset owners ensure lenders have governance frameworks that include fair and transparent lending practices, conservative loan underwriting, and strong servicing, while also enabling an alignment of interests between managers and borrowers.

The Opportunity in Private Debt

The final sub-sector featured in the report was private debt. According to Willis Towers Watson, private debt managers have a long-term mindset, which means that they want to follow long-term market trends like ESG. The report’s authors said they expected private debt managers to have a “deeper understanding” of the importance of ESG strategies compared to public debt managers.

“We think you can make the most impact in private debt,” Srivastava said. “If you’re a private lender lending to a private company, you have a lot of power.”

When seeking to integrate ESG into private debt, asset owners should ensure manager have a robust sustainable investment policy, take steps to ensure shareholders are treated fairly, and track an array of ESG metrics on each loan, according to the report.