Partner Insight: What does it take to achieve true sustainability in fixed income?

To unlock sustainable fixed income with real-world outcomes you need the right combination of expertise, ESG integration and stewardship. 

1)    How does engagement in fixed income work in practice?

It's a myth that engagement in the realm of fixed income is less effective than for equities. Our multi-decade experience of deep engagement with companies issuing debt illustrates this - and we have a solid track record that underlines how effective engagement can be in influencing company behaviour.

Our in-house stewardship team and engagers - including a global engagement team dedicated solely to fixed income - are a critical element of integrating ESG considerations into our investment process. Engagers and credit analysts work closely together; sharing views and opinions; and attending company meetings. This allows us to develop a much better real-time understanding of management's thinking, culture, and processes, as well providing an opportunity to encourage further progress on the path towards sustainability.

2)    How do our strategies express their ESG convictions? 

Because we believe that non-fundamental factors are inexorably linked to credit risk, we typically integrate ESG factors into our investment decisions and assign ESG scores to all credits covered.

Our ESG assessment focuses on the impact that issuers' ESG policies and behaviours have on cash flows and, thus, enterprise value.

In addition to the team's ESG score, issuers that are taken through our Credit Committee are reviewed against the criteria of the investment teams' proprietary sustainability scores, including sustainable development goals, Climate Change Impact and Sustainability Leaders.

3)    What is a QESG score?

We believe that improved ESG behaviours lead to lower risks and volatility and thus better investment decisions. To achieve a fuller understanding of those behaviours, our investment teams use their own proprietary quantitative ESG (QESG) scores as one of several inputs into their analysis.

These QESG scores combine internal analysis with external sources, such as Sustainalytics, MSCI and Trucost to score company's behaviours.

4)     What's with the ESG-risk curve? 

In 2017 as part of an effort to analyse credit risks with greater precision, Federated Hermes developed a pricing model to capture the influence of environmental, social and governance (ESG) factors on credit spreads.

We presented the results of that analysis in our pioneering paper ‘Pricing ESG in Credit Markets', in which we demonstrated that companies with better environmental, social and governance (ESG) practices tended to have lower credit default swap (CDS) spreads, even after controlling for credit ratings. Using the results, we plotted predictions of CDS spreads for given values of ESG scores, drawing an innovative implied ESG pricing curve.

5)     Can ESG factors also affect the pricing of government debt?
 
Our robust ESG-CDS pricing model proves there is a relevant correlation between CDS spreads and ESG risk factors in credit markets. This observation is particularly poignant given that asset owners and fund managers are increasingly looking to ‘screen in' companies seen as ESG and sustainability leaders to reinforce the ESG credentials of their portfolios.

In 2020 we published research which added weight to the argument, illustrating that the correlation between environmental, social and governance (ESG) scores and CDS spreads goes beyond just credit markets but also to government debt too, particularly in developed markets. Long story short: the higher the ESG credentials the lower the (implied) cost of capital.

Whatever your focus, our strategies offer the flexibility to invest in Sustainable Fixed Income with a broad range of preferences in mind. 

This is a marketing communication for professional investors only. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. Issued and approved by Hermes Investment Management Limited which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET.

This post is funded by Federated Hermes