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ESG ratings for fixed income: the Good, the Bad and the Ugly

A growing number of people are looking at how we can contribute to addressing the world’s environmental and societal challenges. So it is of little surprise that there is increased scrutiny on how and where capital is deployed. Investors who are naïve enough to ignore these developments do so at their own peril.

A company, even one that is financially sound, can perform poorly if investors decide that they no longer want to be associated with a particular industry and are no longer willing to lend to it. Funding costs will be impacted, which in turn will affect financial cashflows. A prime example of this can be seen in the tobacco industry. Despite sound financial results, tobacco bonds have persistently underperformed the broader market in recent years. A smaller buyer base has pushed prices lower.

Taking the measure of measurements

But how does one measure environmental, social and governance issues? How do you measure the unquantifiable? Enter ESG ratings. ESG ratings assign a letter rating or a numerical value to a company, essentially denoting whether it is a ‘good ESG company’ or a ‘bad’ one. We applaud these agencies’ efforts to simplify investors’ lives by providing a quick assessment of a company’s ESG practices. But the subjective nature of ESG factors and these rating agencies’ desire to have a scalable methodology means that a single, condensed rating falls short of expectations.

Disclosing what investors want to hear?

ESG ratings providers use consistent, transparent methodologies which enable a scalable model across multiple geographies, asset classes and in turn index construction. Unfortunately, this requires that most ESG ratings agencies rely to a significant extent on companies to self-disclose. This is an approach that has traditionally favoured large companies in developed markets. These tend to have well-established investor relations functions and the time and resource to craft a broad and upbeat ESG narrative.

Walking the talk or ticking the box?

Let’s look at how governance scores work at one of the most prominent ESG ratings agencies, for example. The governance score is a combination of themes which you would typically expect such as compensation disclosures or board independence. However, there is also an emphasis on whether companies have various explicit written policies, whether they conduct employee surveys or even whether specific training programs have been developed. A company could even be marked down for not being a signatory to a particular framework. Having a specific policy around the ‘scope of support and degree for programs and certifications’ for employees is better than not having one. But the combined ESG weighting for such policies is out of proportion.

ESG ratings agencies’ efforts to have a scalable, transparent and consistent methodology have somewhat reduced part of the governance weighting to a tick box exercise. Larger companies which can afford the time and resource to write up policy documents fare better than their smaller counterparts. It’s worth highlighting that the crux is on whether an actual policy exists or not, and not on whether the company has actually adhered to the policy!

Different interpretations and scoring

The other inevitable aspect of trying to quantify subjective factors (after all, ESG will mean different things to many different people) is that there is very little consistency across various ESG ratings agencies. This isn’t necessarily a problem. But these studies do serve to highlight that no-one (ourselves or fund selectors) should rely wholly on one source of ESG information.

So what does this all mean in practice? Is it possible to integrate ESG into fixed income investing? We believe so. But it is not by trying to engineer a fund to have a good overall ESG rating. As a side note, the ESG ratings agencies typically have a very small number of very badly rated and very well rated companies. In reality, this means that a fund could easily engineer a good ESG score by avoiding/gaining exposure to one or two companies. In other words, a very small number of holdings could distort the fund’s ESG rating. This is especially true for more concentrated funds.

Manifest truths are still the strongest indicator

Rather, the way we prefer to look at ESG is by applying good old fundamental analysis and integrating ESG factors, as opposed to overlaying them on top of a fund. Instead of looking at how many policies a company has, we prefer to focus on where poor business practices or exploitative social and environmental activities could threaten sustainability of cashflow. Instead of looking at whether a company is a signatory to a particular initiative, we prefer to look at which technologies and developments risk making certain sectors redundant. Instead of looking at whether a company has an explicit policy on energy use, we prefer to look at how much carbon emission it emits – and more importantly the trajectory of such emissions and whether these could threaten the sustainability of cashflow further down the line.

ESG as one of many factors

The other thing worth keeping in mind is that, by their nature, bonds most often have a maturity date. Investing in an auto company for the next 30 years is very different to investing in it for the next five. As such, we are not in favour of having an exclusive policy which would leave the fund constrained. Instead, we prefer to take a pragmatic approach and consider ESG and financial factors to be intermingled. In the same way that we would not exclude a company from our investing universe on the basis of a financial metric, we would not exclude a bond from our investment universe because it has a bad ESG rating. Rather, we ask ourselves if we are being compensated for the risks that a particular bond carries, whether they may be of a financial or an ESG nature.

ESG investing has come a long way. While trying to simplify complex, subjective and not often tangible factors has its flaws, great headway has been made in terms of what information investors have access to. This enables us to make more informed decisions. We are encouraged by the increased information from companies and will continue to support the drive for increased transparency on financial as well as ESG factors. Regrettably, there is no shortcut to integrating ESG.

About the author

Grace Le, Fund Manager at Artemis

Grace is a fund manager in the Artemis fixed income team. She joined Artemis in December 2019 from Kames Capital, where she was co-manager of a range of investment grade bond funds, including the Kames Investment Grade Bond Fund and the Kames Investment Grade Global Bond Fund. Since 2015, she has also covered various sectors including automobiles, pharmaceuticals and insurance. Before joining Kames, she started her career at PwC in 2012, where she qualified as a chartered accountant. Grace graduated from Imperial College, London with a degree in Mathematics. She is an ACA and CFA charterholder.

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