Fixed Income  

ESG investing for bond funds

This article is part of
The Guide: Half-year review

There has been a meaningful change in the dialogue around environmental, social and governance (ESG) consideration in the past six to 12 months.

Investors and prospects are no longer asking: “Do you incorporate ESG factors in making credit investment decisions?” They are now asking: “How do you incorporate ESG factors in making credit-investment decisions?”

This confirms that the integration of ESG factors is no longer a marginal concern. Investors now expect that credit fund managers analyse ESG risk factors as part of the investment process, something Hermes has been doing for many years. Also, the demand that managers consider ESG factors is no longer the provenance of Nordic institutional investors.

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Enough intellectual capital has been thrown at understanding the connection between ESG risks and total returns that we know it just makes investment sense.

Institutional investors are now asking credit managers about ESG integration. But what has surprised us recently is how much more private wealth managers and financial advisers are asking about the space. 

In retrospect, looking at demographics this makes complete sense. Millennials comprise 27 per cent of the world’s population, according to BofA Merrill Lynch Global Research. If you include the so-called Generation Z, that number jumps to 59 per cent. This cohort represents $21trn (£16.4trn) in income: a greater proportion of their population in wealth in the US, the UK, parts of Europe and China. 

Millennials are now coming of age and into their own wealth. Research shows that this generation cares more about the inclusion of ESG factors and so-called ‘impact investing’ than older generations. Millennials are significantly more likely to believe it is possible to receive returns that are every bit as good as expectations for the market while considering ESG and impact investing.

One report reveals millennials are attracted by the “opportunity to create a long-term, sustainable portfolio”. Four in 10 believe firms with good ESG practices are less susceptible to business risks, and nearly the same number think these good corporate citizens deliver superior financial performance. This confirms what we know anecdotally from meetings in the private wealth space.

Demographics are having a palpable impact on investment priorities. Millennials want to invest in a holistic way. They are asking these questions of their financial managers who are then asking us the same thing: “How do you incorporate ESG factors in making credit investment decisions?”

As credit managers we are compelled to include the analysis of ESG risk factors when making investment decisions for the reasons noted above. But how do we price these risks?

There is a plethora of tools to throw at the challenge of pricing operating and financial risks, but a dearth of the same is available for pricing ESG risks. There is also an abundance of academic literature out there which documents robustly that good ESG practices translate into better financial outcomes, for both firms and investors.