Jay Sivapalan, Head of Australian Fixed Interest at Janus Henderson, discusses the role fixed interest investment managers can play in representing clients and society more broadly on ESG factors, and the importance of company engagement and a ‘quality before price’ investment philosophy.
Evolving investor preferences and expectations
Investors have long had high expectations for what they want in return for investing their hard-earnt savings. These expectations go beyond the return of capital and return on that same capital. For investment managers, at the heart of their fiduciary responsibility has been putting the client and their preferences first.
In recent years, there has been growing awareness that the decisions individuals, entities, governments and society at large make have a profound impact on Environmental, Social and Governance practices (ESG). Investors have also grown to realise the powerful impact they can have with their capital choices.
All around the globe, investors are becoming more aware of the issues surrounding ESG factors and holding managers of their capital to higher standards in a bid to have a greater positive impact on the world. Today there is an expectation that investment managers will play a leadership role in shaping the behaviour of corporates and governments through the management of their clients’ capital.
|"Investors expect their managers to be an advocate of strong ESG standards and an ambassador with their hard-earnt savings.”
Jay Sivapalan, Head of Australian Fixed Interest
A ‘quality before price’ mindset to investing
Integration of ESG considerations in investment decision making has come a long way in recent years, and this is particularly true in the case of fixed income investing. Integration means different things to different investment managers and there is no universal way to integrate ESG risk analysis into an investment approach. Some use it as part of their bottom-up credit processes, while others use it in top-down portfolio construction. In some instances, it is taken a step further, with investment managers developing positive or negative screens to exclude or even upweight companies based on a particular ESG score or metric.
The Janus Henderson Australian Fixed Interest Team (the “Team”) believes any fixed income approach to ESG risk considerations should be aligned with the underlying approach to credit investing. We feel that this consistency leads to the best outcomes for clients and portfolios.
Investment processes, including bottom-up fundamental credit analysis, which at the core determines ‘who’ we lend our investors’ capital to, has long taken a range of key attributes into account such as business risk, financial risk, management and ESG factors.
For our part, we have employed a ‘quality before price’ mindset to this process over two decades. Put simply, for some corporate debt issuers, there’s no price at which we will invest clients’ capital. This view is borne out of recognition that there are symmetric risks involved when investing in bonds. The best we can hope for is payment of interest and the return of investor principal at maturity, the worst case scenario can mean the complete loss of capital if the issuer defaults with no recovery.
Looking back at the Global Financial Crisis, defaults included ABC Learning Centres domestically and Babcock and Brown in the US. In the wake of the COVID-19 crisis, we are reminded that defaults of large corporations are a clear and present threat. The travel restrictions related to the pandemic contributed to Virgin Australia entering voluntary administration, most likely leaving bondholders with cents on the dollar.
We find that a ‘gated’ approach, which after rigorous credit analysis only finds the ‘stable and sustainable’ companies making it to our approved list, an effective way of screening out those that are priced cheaply for good reason. This gated approach includes ESG considerations and is the primary reason issuers like Lendlease, Nissan, Thames Water, Crown Resorts and others are currently outside our investable universe.
Developments in bond markets promoting tangible and positive ESG outcomes
It isn’t just the adoption and consideration of ESG risks that is changing rapidly. The tools investors have to assess and categorise the opportunity set is also evolving, as are the types of instruments available for investors.
The 17 Sustainable Development Goals (SDG’s) pioneered by the United Nations offer investors and companies the ability to clarify how they are contributing to these important goals. In addition, we are seeing the emergence of transition bonds where investors can directly assist companies as they transition their operations into a zero-carbon world and meeting the targets set out by the Paris Agreement.
In Australia we are also seeing the take up of Sustainability Linked Loans and Bonds, where the coupon paid by the company can change based on how that company performs against a series of benchmarks, such as an ESG rating by a third party or changes to company carbon dioxide emissions. The phrase “the only constant is change” very much holds true with regards to ESG.
Company engagement is key
One thing that has not changed in our eyes is the importance of company engagement. As the world grapples with the implications of COVID-19 on all levels, it is vital that we understand how the companies we invest in are tackling this pandemic. As a general statement, the companies we invest in are putting the health and safety of their staff and clients first. From an investment perspective, they have entered this crisis in strong shape, with robust balance sheets and little near-term refinancing to do.
Our direct engagement with companies extends beyond COVID-19, where distinct ESG issues exist for certain companies. At the forefront of our approach to credit investing is the commitment to invest in companies that are stable and sustainable in credit quality. Engagement with issuers stands at the top of the priority list in this regard.
We believe that active ESG engagement can improve the credit quality of a company over time – either arresting deteriorating quality or improving it from current levels. Ultimately an active approach to ESG issues should result in better investment outcomes for our investors as a result.
Some examples of ESG issues we are currently working with companies on include cultures of bullying and harassment, adverse environmental impact, weak governance practices, diversity and inclusion.
|"We see our ability to engage with senior management on important credit issues, including specific ESG issues, as an integral part of our investment approach as well as our responsibilities to our clients. Engagement shapes our opinion on the creditworthiness of the company as well as whether ESG risks are well understood and are a high priority within a company.”
Ashley Kopczynski, Associate Portfolio Manager, Credit & ESG
While equity holders can exert influence via proxy, credit investors can exert their influence on companies by withholding capital from bond deals. When companies raise money via bond issuance, it is the market’s opportunity to weigh up that company’s prospects and to support it with investment or not. As ESG considerations continue to gain momentum, arguably companies with weaker ESG metrics will experience wider credit spreads, ultimately needing to pay a higher cost of capital due to weaker investor demand.
Focus, ownership and resourcing for effective issuer engagement
As an investment team, we play the role of ambassador for our clients on ESG matters and uphold the robust integration of ESG practices in our investment processes. Having an ESG focus and accountability on these matters in our view yields the most tangible and effective results. We take accountability for aspects of investment strategies, from macro-economic research to bottom-up credit research, as well as in the execution of our interest rate, relative value, sector and credit strategies. Consideration of ESG matters is no different.
We formalised our ongoing commitment to ESG considerations through Ashley Kopczynski’s role being broadened to include a specific focus on ESG engagement with issuers. In addition, we have appointed Liz Harrison to the newly created role of Fixed Interest Analyst – ESG, where she too will be involved with active company engagement. Liz brings over two decades of experience in fixed interest markets and her passion for ESG and observations of corporate debt issuers over that time is a valuable addition to the Team.
|"I am very passionate about ESG and am happy to be joining a team that appreciates the importance of having a process that’s real, tangible, explainable and demonstrable. In our work we have the ability to shape corporate behaviour and practices for the betterment of society.”
Liz Harrison, Fixed Interest Analyst – ESG
With such a dedicated focus and ultimate accountability, we are finding that meaningful conversations are being had with issuers where they in turn are making tangible changes to the way they operate. This is ultimately what our investors desire and can only be a positive for all stakeholders.
Much like the industry, our approach to ESG is constantly evolving as we build on our long-standing experience. We have been fortunate enough to have our products included in ESG-specific model portfolios and while we are certainly very appreciative of this recognition.
ESG considerations are an ongoing and evolving concept that we are motivated to excel at.