TwentyFour Asset Management launched its first sustainable fund in January 2020 and I would like to share some of the lessons we have learned from our first year of sustainable bond investing.
One of the biggest challenges we’ve found to date when applying ESG or sustainability within a fixed income strategy has been patchy data disclosure by bond issuers. This is improving all of the time but remains far from perfect. However, because we use an active, proprietary ESG scoring system that is conducted directly by our portfolio managers, we can aim to gradually fill in the information gaps. For example, for the past year or so we have been putting our Carbon Emissions Policy to use identifying bond issuers that do not publish Scope 1 and 2 CO2 emissions data and pushing them to do so (more on this later). As a result, at the end of February 2021 some 77% of the portfolio held by our first sustainable fund was covered from this perspective, with the remaining gaps mostly limited to US Treasury holdings and some RMBS positions. It is worth noting here that data availability tends to be poorer at smaller companies, which are more prevalent in the high yield bond market. This doesn’t necessarily mean their underlying ESG performance is poor; it is more likely that their size or growth rate makes it difficult for management to allocate resources to data provision. In further defence of high yield issuers, we also appreciate that many bigger companies tend to score better precisely because they have the resources to ‘profile’ themselves well when it comes to ESG.
We see engagement as a critical element of sustainable bond investing, since this is where we believe bond investors (and particularly active managers) can make the biggest impact on corporate behaviour. Bond investors may not have the AGMs and votes that shareholders do, but big companies often come to the bond market several times a year for funding and from our experience of talking to them they increasingly appreciate what a failure to engage today might mean for their cost of capital tomorrow. As we mentioned, one area where we have had particular success with our engagement is on CO2 emissions data. Annington Funding and Great Rolling Stock are two examples of issuers that have responded positively to our requests and included the data in subsequent reports, whereas we felt we were compelled to exit a position in Student Finance because of its poor response to this question. Another interesting example would be the case of Porterbrook Rail Finance, where the company agreed to report the emissions data but our position matured before this was done and the management subsequently refused to give non-investors access to what they deemed non-public information; we have since pressed them to reverse this decision and informed them that a failure to do so could prevent any future investment from those not currently invested with them.
Most people, investors or not, will have some idea in their minds as to what they consider a ‘good’ or ‘bad’ company when it comes to ESG. However, ESG scoring isn’t this binary – companies can be judged on a vast number of data points and extra layers of qualitative analysis, and most models aim to boil this process down to one figure for portfolio screening purposes (we use a number out of 100, whereas other models may allocate using 0-50 or a letter from A-F for example). Because of this some ESG scores often come as a surprise to investors. Our ESG data provider Asset 4, for example, scores plastic bottled sugary drink maker Coca-Cola, energy company Repsol and cruise operator Royal Caribbean much higher than electric car producer Tesla. Despite using much the same data, other providers may arrive at very different scores for these companies, depending on the weighting their model gives to different elements of E, S and G in calculating the final score. This is one of the reasons we are critical of overly rules-based ESG scoring systems that often blindly follow one methodology or index. We believe that as this industry grows, end investors in passive strategies may be surprised to learn the kind of names making it into their portfolio based on whatever rigid criteria the strategy deploys. By contrast, we prefer an active portfolio manager-driven approach that enables us to override scores from our raw data provider where we think necessary, as well as applying our own qualitative judgement to determine whether our clients are being adequately compensated for the ESG risks we see.
A few months ago we concluded that green bonds generally didn’t make much sense for investors, and while this fashionable market continues to grow rapidly, we haven’t changed our overall opinion. Recent press reports suggest that other large asset managers are now beginning to apply what we consider to be some very welcome scepticism to green bonds, adding to the sense that some governments and companies are able to use such issuance to misrepresent their green credentials while lowering their funding costs. If we take sovereign green bonds, for example, we think governments are elected to serve the interests of their nation, making investing in a more sustainable future a sensible policy that shouldn’t necessarily require attractive financing. We accept that if governments can achieve cheaper funding through green bonds then they are serving the taxpayer by doing so, but in truth they are only able to do this because at the moment investors have such high demand for the label. On one level this is encouraging as it shows asset owners are willing to fund the transition to a more sustainable future, but they are often suffering reduced returns (and possibly results) while demand is greater than supply. Anecdotally we are not surprised to hear that investment banks’ bond origination desks are scouring their clients’ operations looking for a green bond angle. Ultimately we need the green bond market to itself be sustainable in the long run, but we see a genuine risk that the market becomes discredited.
When the ESG movement first began to take hold in fixed income, asset managers in particular were very focused on the G. After all, Governance is a relatively broad concept that speaks to various aspects of a company’s general management and culture, and the buy-side would have been familiar with evaluating investments on this basis long before the ESG acronym was born. Now though we are seeing an increased focus on the other two letters, which is being driven partly by asset owners themselves seeking more robust approaches to E and S. In particular, while carbon emissions are a given, social factors such as the percentage of women on boards or the provision of services to underserved parts of the community are increasingly being seen as effective indicators of a company’s general approach to risk management and ethical practices. A lack of focus in these areas can be a red flag for sustainable strategies.
While it might seem that ESG has been around forever, in reality the movement is still in its infancy, especially in fixed income, and it is easy to point out the inconsistencies and discrepancies in many areas. However, ultimately the capital markets continue to shift towards promoting better societal outcomes at pace, and we believe the direction of travel is overwhelmingly positive.
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