ESG factors making inroads in fixed-income portfolios?

0

Responsible-Investor.com reports today that “bond managers are working to add environmental, social and governance factors to their investment processes to meet growing client demand for responsible fixed-income investments.” RI states that a number of major institutional fund managers, pension funds, and sovereign wealth funds in Europe and North America have “taken strides to incorporate ESG factors into investment processes.”

Although it is difficult to find information linking environmental and sustainability factors to default risk, the connection between corporate governance and default risk is at least theoretically plausible

Most managers see a strong case for including governance in investment decisions. “There’s been enough corporate governance catastrophes that have ended up with companies defaulting” to lead managers to look much more closely at governance processes, said Emma Hunt, senior investment consultant in Towers Watson & Co.‘s sustainable investment team. “They’ve really upped their game.”

Credit-rating agencies have included corporate governance in their bond ratings methodologies for years, and AXA Investment Managers found in a 2009 in-house study that good corporate governance reduces default risk, and leads to better credit ratings and lower debt costs. “The corporate governance of a company is a material issue in understanding the risks and opportunities associated with its ability to preserve and create value for its shareholders — as well as meet its debt obligations to bondholders in a timely manner. And while their strategic focus may differ, the interests of shareholders and bondholders in ensuring the companies they are invested in have sound corporate governance policies and practices are aligned,” according to AXA IM’s study, titled “Can corporate governance take — partial — credit for fixed-income performance?” Hunt compared the effect of ESG factors on bond performance to crocodiles in the water — a lurking danger that nobody sees until it’s too late. “The thing with crocodiles in the water, it’s a bit all or nothing,” said Ms. Hunt, who is based in Reigate, England.

An interesting opinion on the connection between governance and (perceived) default risk is presented by Christina James-Overheu and Julie Cotter, professors at the School of Accounting, Economics and Finance, University of Southern Queensland. In a 2009 study investigating whether the quality of a firm’s corporate governance practices and its sustainability disclosures are inversely related to its assessed default risk, they wrote:

It is expected that high reported standards of corporate governance will reduce the assessment of a company’s default risk by lenders, underwriters and ratings agencies, and therefore reduce the cost of debt for such companies. A corporate governance index based on annual report disclosures was developed to rate each company’s corporate governance quality. Derivation of this index was centred on corporate governance indicators suggested by prior research and best practice; particularly the Australian Stock Exchange “Principles of Good Corporate Governance and Best Practice Recommendations”. It is similarly expected that the voluntary disclosure of sustainability information (Corporate Social Reporting or CSR) will enhance a firm’s management reputation. The assessment of default risk is captured by a firm’s individual credit rating supplied by Standard and Poor’s. Our results indicate that neither annual report disclosures about corporate governance practices nor sustainability disclosures are significantly related to assessed default risk when firm size is controlled.

This study suggests that assessed default risk is not significantly affected by ESG practices and disclosures, but it suggest no definitive answer as to whether such practices and disclosures are connected to actual default rates. Further research is needed.

Share.

About Author

Leave A Reply