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Vishal Khanduja

The rise of responsible fixed-income investing 

By Vishal Khanduja & Brian Ellis
6 minute read

2020 was a pivotal year for responsible investing, especially in fixed income.

For more than three decades, Calvert has viewed responsible investing as a positive force for influencing corporations. During the COVID-19 pandemic, the contributions companies make – or could make – toward a sustainable world never loomed larger, whether producing vaccines, restocking food shelves or managing global supply chains disrupted by the global economic slowdown.

The pandemic heightened the awareness of environmental, social and governance (ESG) factors as drivers of financial performance – a trend that has been growing for the past several years. Along the same lines, we believe COVID-19 has fostered a broader understanding of how valuable ESG factors can be in linking corporate activity to the health and wellbeing of society and the global economy. 

Perhaps most ESG fixed-income headlines focused on the growth in “green” bonds, which the Forum for Sustainable and Responsible Investment (US SIF) defines as “impact investing... aimed at solving social or environmental problems.” 

Indeed, green bonds are the largest component of sustainable issuances tracked by the Climate Bonds Initiative (CBI), and have surpassed $1 trillion in outstanding market value – roughly the size of the US high-yield market.

Green bonds further gained global significance, with issuance in all major regions (developed and emerging) and principal fixed-income sectors – they led the sustainable bond category in issuance in 2020 with $375 billion, and are projected to grow sharply in coming years. 

But green bonds are just part of the growth of the broader sustainable fixed-income trend, which can also be seen in its increased adoption by asset managers:

  • The number of taxable, sustainable open-end and exchange-traded funds in the Morningstar universe increased by 33 per cent to 64 in 2020. Two new sustainable municipal bond funds brought the number in that sector to 10, according to Morningstar, Inc.
  • Fixed-income departments are devoting increasing resources to ESG-related research. 
  • ESG focus has expanded beyond investment-grade corporate credit to include other sectors such as municipal, high yield, emerging markets, securitised and floating-rate loans. 

A number of policy and regulatory developments in 2020 also contributed to the growing acceptance of responsible fixed income. The European Central Bank (ECB) directed bond purchase programs to account for climate risks and buy green bonds. The US Federal Reserve took steps to formally declare climate risks to be systemic, which need to be monitored and addressed by banks. The EU issued milestone regulations on sustainable finance disclosure regulation (SFDR) and taxonomy – a classification system that establishes a list of environmentally sustainable economic activities (see sidebar on page 7.) 

New green deals captured headlines in the US and Europe – climate change featured prominently in US elections and the European Climate Pact of December was the first big initiative of the European Green Deal. 

Many countries are pledging to achieve net-zero emissions, and a large part of the associated investment will be funded by debt. The Biden administration indicated its support for “effective carbon pricing,” according to Treasury secretary Janet Yellen, in January testimony before Congress. The US Department of Labor in March 2021 said it would not enforce restrictive ESG fiduciary standards adopted by the Trump administration in the face of overwhelming opposition from commenters.

Responsible investing continues to make large inroads among both individual and institutional investors, jumping 43 per cent to $16.6 trillion between 2018 (the last reporting period) and 2020, according to US SIF. Consistent with the UN’s Principles for Responsible Investment (PRI), which calls for strategies that “benefit the environment and society as a whole,” institutions comprise $12 trillion, or 72 per cent, of the US SIF total.

Asset owners are largely following Europe’s path, where concerns over climate change have been a big driver for integrating ESG with traditional investing. This is true across all investor types, but the size of institutional investors was particularly notable.

ESG fixed income and performance 

One of the foundational beliefs of responsible investing is that all companies must address a range of ESG factors that can materially affect business outcomes. As a corollary, companies that most successfully manage ESG factors can gain an edge in long-term financial performance and create positive societal change – these are, in our view, mutually reinforcing efforts.

While most research has been on equities, the potential for ESG factors to enhance performance in fixed income has increasingly been the focus of study in recent years. 

A 2018 survey analysis by the World Bank observes: a growing body of research shows that ESG factors are material credit risk for fixed-income investors. The evidence suggests that incorporating ESG into fixed-income investing should be part of the overall credit risk analysis and should contribute to more stable financial returns. It also dispels the myth that incorporating ESG means having to sacrifice financial returns. 

ESG investing is increasingly becoming part of the mainstream investment process for fixed-income investors. A recent study by BofA Global Research bears out the World Bank’s assertion that incorporating ESG does not mean “having to sacrifice financial returns.”

A 2019 study in the Journal of Applied Corporate Finance examined the mechanisms that link ESG performance to credit risk. It found that companies with strong ESG performance experienced fewer surprises – and lower volatility – in response to both good and bad events. As examples, in the transportation sector, firms with high ESG performance endured fewer labour problems, unexpected strikes and lay-offs. In the oil and gas sector there were fewer industrial accidents. In technology/media/telecommunications companies there were fewer terminated business contracts.

All investors have a right to know whether responsible investing is contributing to the broad goal of substantive progress toward a sustainable economy. To achieve that, we firmly believe that broad impact must be material, measurable and reportable. 

To that end, Calvert is developing a range of scores and grades for areas such as cleantech, human rights and workplace diversity, greenhouse gas (GHG) intensity and water stress. As an example, as of 31 December 2020, relative to the Russell 1000 Index, the Calvert US LargeCap Core Responsible Index has 88 per cent lower fossil fuel reserves, 41 per cent lower carbon emissions, and 83 per cent lower toxic emissions.

Transparency is guiding the decisions of a growing number of investors, which in turn scales up the impact. Issuers, too, respond to such signals by modifying their culture and operations – initiatives that are further encouraged through engagement with managers and investors.

For such reasons, we believe that impact reporting eventually will take its place alongside total return, Sharpe ratios, tracking error and other key evaluation measures. Calvert is committed to the belief that lending should be a positive force for social change and a source of long-term value.   

Vishal Khanduja, investment-grade fixed-income portfolio manager and Brian Ellis, investment-grade fixed-income portfolio manager at Calvert Research and Management