Ethical investing: fixed income
For financial professionals only
The safeguard in our ethical solutions
Fixed income is held across our Parmenion ethical profiles, particularly at lower risk grades. This part of the portfolio aims to provide steady returns, as well as diversification versus equities, and downside protection during market falls. But how ethical is fixed income?
Investors still have their say
Unlike equity investors, bondholders don’t get voting rights. That means some investors assume they don’t have a voice to engage with the companies they’re lending money to in the fixed income markets. This is not the case:
- Bondholders sit at the top of the capital structure and have a lot of influence over how companies are run. When a company issues more shares to raise capital, they’re simply diluting the ownership rights of the shareholders. For fixed income, the lenders of a new bond issue are providing new capital to the company. They’re in a strong position to include terms in the covenant about how the capital will be used and disclosures the borrower must make.
- It also stands to reason that companies with better management of environmental (E), social (S) and governance (G) risks can borrow at a lower rate, so companies have an incentive to run their business in a sustainable manner.
Why ethical issues should be on your radar
Investors in fixed income ignore ethical issues at their peril: the average term of investment grade credit is around 13 years. This has increased from around 9 years in the early 2000s (source oecd.org, 2019). Bondholders need to be confident of the issuing company’s ability to repay, and it’s impossible to ignore issues like climate change. These could cause the company to default or the market value of the bond to fall over the investors’ holding period (whether they hold to maturity or sell before that point).
While good bond managers have always considered governance risk factors for the companies they lend money to, they’re placing more importance on environmental and social risks which could cause financial loss. Increasingly “mainstream” managers who don’t have a particular ethical focus are screening out sectors seen to have the highest environmental risks (coal) or social risks (tobacco, pornography and weapons).
For more ethically-minded investors, the green and social bond sector is growing rapidly. These bonds are issued to tackle specific environmental or social issues – for example, green bonds can support clean energy projects, while social bonds have recently been issued to help fund the fight against COVID-19. The fixed income managers in our ethical solutions have some exposure to social and green bonds, where they find attractive opportunities.
What about short-dated fixed income/cash?
Ethical considerations are also important for short-dated fixed income and cash. We expect managers in this space to undertake detailed due diligence of the banks they’re depositing money with or lending to on a short-term basis. This involves a financial assessment of the bank and its E, S, G factors. For example, what is the bank’s governance structure and how do they score versus competitors on transparency, accounting policies and quality of audit? How exposed is their loan book to environmental and social risks, and how do they take these risks into account in their underwriting process?
The Partnership for Carbon Accounting financials aims to standardise the carbon emissions reporting for the financial sector across their value chain through the “Corporate Value Chain (Scope 3) Accounting and Reporting Standard”. There are currently 67 banks with over $6trn financial assets signed up to this initiative. This additional disclosure by banks should enable ethical investors to have more visibility of their carbon footprint and help them choose which bank to work with.
Leading managers have a clear ethical strategy
As with equities, leading ethical managers in fixed income will have a clear ethical strategy and a robust process for how they select securities to achieve this. They will analyse the exposures of the companies they invest in, their supply chains, and will measure how their portfolio is performing from an E, S, G standpoint, as well as pure financial performance. For example, the fund managers should understand how the investee companies interact with their communities and how they align with the UN Sustainable Development Goals. They should also be able to provide examples where they’ve engaged with company management with positive results.
This article is the first in a 3-part series on asset class considerations for ethical fund managers. In the second part of the series, we’ll be looking at equities.
If you enjoyed this article, why not take a look at our coverage on The role of social bonds.
“The above article is intended to be a topical commentary and should not be construed as financial advice from either the author or Parmenion Capital Partners LLP. If a client wishes to obtain financial advice as to whether an investment is suitable for their needs, they should consult an authorised Financial Adviser. Past performance is not an indicator of future returns.”
Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation. All investment carries risk and it is important you understand this. If you are in any doubt about whether an investment is suitable for you, please contact your financial adviser.