What does ESG integration mean for fixed income investors? Let’s park the thorny question of government bonds and look at credit.
One problem we have is that there is no consensus on names. ESG, Responsible, Green, Transition, Ethical, Sustainable, Social Impact investing all give rise to a huge variety of interpretations – even for the same term.
At RLAM we have managed 'Sustainable' strategies for over 10 years, based upon companies that offer goods and services that are a net benefit to society or demonstrate ESG leadership. As you can see this is subjective, even when we have clear criteria for assessment. For the EU, Sustainability is much more focused on the 'E' in ESG.
I was drawn to an article in last Friday’s Financial Times (FT) called 'ESG playbook for bond investors needs a rewrite'. I am not sure I agree, partly because there is no playbook to rewrite. More fundamentally, a view put forward in the article is that ESG integration is about telling clients what should be in portfolios. From my viewpoint this is not ESG integration – it is Ethical investing. For RLAM, integrating ESG is about risk assessment – looking at risks and evaluating what yield premium over the risk-free rate is required to take on the whole range of risks. ESG integration is not an ‘add-on’ and certainly not a tick box exercise. Actually, I don’t see how credit research can be undertaken without integrating ESG. But, then again, it shows the problem of definition.
There are some key differences between bonds and equities and the article outlines them well. Bond holders are not owners, we have to manage interest rate characteristics and there are multiple choices to make within the capital structure of a single issuer. This means much wider coverage and also, due to the asymmetric nature of credit returns, more diversification in portfolios than seen in equity strategies. We are putting in a lot of effort to improve our ESG integration, working closely with our Responsible Investment team and, undoubtedly, the industry attention on these risks has sharpened our focus. This has meant more resources, more data usage, and better explanations of what we mean by ESG integration.
Defaults and credit spreads
Back to markets. Questions I am being asked more frequently are: what is the outlook for defaults? Do credit spreads offer value?
I think I can answer both together. Basically, I think defaults in both high yield and investment grade will pick up in the next few years and that credit valuations are attractive. Why do I think defaults will increase? This is based upon higher financing costs, economic slowdown (possible recession) and greater cost pressures. However, if we look at sterling investment grade, the current credit spread already offers a very significant premium over that required to compensate for default risk. Even with a pick-up in defaults, the required compensation would be around 30-40bps, compared with the current 120bps. OK, this is based upon historical analysis and things may change. But the data does cover some pretty extraordinary times. I believe that for long-term investors, who can tolerate lower liquidity, the credit spread premium over government bonds is one of the more reliable sources of extra return. No guarantees and you need to live with volatility – but the odds are in your favour.
What about total return? I still see scope for long bond yields to rise but at the short end I think value is emerging. With both the US and UK government markets pricing in official rates at 2.5% or above in 12 months’ time and a credit spread premium on top, I think shorter dated credit is definitely worth a look at.
Government bonds and credit
However, it was another tough week for bonds. US 10-year yields moved above 2.75%, the highest level in three years. UK bonds did not rise as much, but still closed at 1.75%. The French election was a side-show in markets, with President Macron still set for re-election. French 10-year bonds reflected the general move, hitting 1.25% in the latter part of the week. Globally, implied inflation moved higher at shorter maturities but this was not sustained across the curve. As an example, 10-year UK inflation rose to 4.4% but moved a bit lower, at 3.6%, for 30-year bonds. Real yields continued to rise, with the US 30-year yields moving decisively back into positive territory. In the UK the 30-year real yield has now risen by 60bps this year, although still negative at -1.7%.
Credit spreads continued to squeeze tighter with sterling investment grade bonds a couple of basis points lower. Some bonds are now significantly below par, being issued when government yields were lower. Longer dated bonds for BAT, Shell, National Grid, Wellcome Trust, and several housing association are trading at or below 75% of face value. For bonds with asset backing, such as the social housing sector, this means that collateral cover is higher – for those buying at these lower prices.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.