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Jan 28, 2020

How fixed-income investors are adding sustainability to investment decisions

Q&A with Hermes Investment Management on adding ESG to debt investing

Why should fixed-income investors factor sustainability into their investment decisions, and what are the approaches available to them? What drives an impactful engagement with a credit issuer? These are some of the key questions Hermes EOS clients and prospective investors ask about ESG and engagement in fixed-income markets.

Here Mitch Reznick, head of research and sustainable fixed income, and Aaron Hay, lead engager for fixed income, provide the answers. 

Let’s start by defining some of the terminology of sustainable investing.

Reznick: Basically, sustainable investing has two objectives. Firstly, a return on investment, which is fairly typical. But the second objective is an extension of that: investing not only to seek returns from the investment, but also seeking a return through society. Sustainable investing has been around for years but has recently gained momentum, partly due to the well-publicized effects of climate change. So there’s a real focus on these kinds of issues at the moment.

In terms of defining different types of sustainable investing, we can break them down into broadly three categories: ESG integration, thematic and impact investing. ESG integration is mainstream investing at Hermes, where we assess and price the materiality, probability and timing of non-fundamental factors, environmental and social governance issues. 

The second, thematic, is when investors want more of a tilt in their investment style toward the sustainability theme – for example, exclusions to certain sectors like coal or tobacco. And third, impact: this is where an investor can really have a constructive impact, or voice, in how a company is run. With impact investing, you can change the way a company behaves, to truly create positive change to the environment or society.

What does stewardship and engagement mean, and how does the team at Hermes do it?

Hay: We engage companies on environmental, social and governance issues. Increasingly over the last few years this has involved engaging on strategy and risk issues as well. The way we do this at Hermes is a bit different because we have our own stewardship engagement business, Hermes EOS.

Hermes EOS is one of the tremendous assets that allow us to deliver a unique engagement capacity. It has a team of about 30 people, advising on around £634 bn ($698 bn) of assets for around 45-50 external clients. And these companies, pension funds and long-term asset owners have entrusted us to engage and steward these companies on their behalf. 

To give you an example of this, we do a lot of very intensive engagement in automotive value chains and energy value chains and, increasingly, the social and the environmental issues that affect these sectors. This is everything from workforce stoppages to the companies’ commitments to climate change. We have the expertise and the engagement capability of our EOS team to be able to directly engage with these companies on these issues and we have the insight and the capacity and capability of our investment teams to understand how the company is performing relative to those issues, as well as on a financial basis.

What attracted you to working in this area?

Hay: The ability to influence and change companies from within, where you have a real and legitimate seat at the table, where you can ask for change – that really appealed to me. I was so pleased and surprised in my first couple of months to see how influential EOS can be, and how much companies sit up and listen when you say I’m here on behalf of 2 percent of your investors. 

We see a lot of myths associated with ESG, such as reduced returns. Do you think engagement actually delivers returns? 

Reznick: Going back to thematic versus impact investing, if you exclude part of a portfolio and an investor can’t invest in that portfolio, then one could say you are reducing the amount of return. And I think that was one of the challenges ESG advocates faced a few years ago. But now that we’ve seen the power of ESG integration and engagement, and how they can enhance returns, we are finally in a position to be able to push back and say ESG does not take returns away. 

The team has done some research recently – what did you discover about the relationship between ESG and credit spreads?

Reznick: We were so frustrated by the lack of research on assessing and pricing credit risk in the ESG space that we created our own tools. We conducted a quantitative study on attaching ESG factors to credit risk and discovered, firstly, that there is a relationship between ESG risks and credit spreads. The higher the risk, the wider the spreads, and the reverse is also true. And secondly, that it was not entirely explained by credit ratings. So we went on to draw ourselves an ESG credit curve – an implied credit curve based on the level of QESG scores and where the credit curves lie. And that’s been an important – and I’d say pioneering – step in terms of trying to attach ESG factors along with returns in credit.  

How do you get companies to open the door to you? Are you ever told to ‘go away’?

Hay: I’ve never had that reaction from any company. I’ve certainly had a few doors that have been opened and then there’s been a disinterested conversation, but I think that’s extremely rare. We have a unique position with Hermes EOS: as it has such a large amount of assets under advice level, we are able to tell companies about some of the investors we are representing and that gets their attention very quickly. 

I think, however, that moving to the next level where it becomes a two-way dialogue, companies will be more open, more frank. They will be more likely to take on advice. That only comes with credibility and quite frankly, developing a relationship, which takes time.

This article originally appeared on the Hermes Investment Management web page here.

The views and opinions contained herein are those of Mitch Reznick, head of research and sustainable fixed income, and Aaron Hay, lead engager for fixed income, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. 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. Past performance is not a reliable indicator of future results.

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