We find that companies and governments that manage ESG risks poorly typically manage other risks poorly. While it can be challenging to integrate ESG factors into fixed income investing – we strive to systematically consider ESG factors as part of our investment process.
Poor corporate and regulatory governance are recognised contributors in most corporate failures. In addition, dangerous environmental and social practices can lead to significant financial cost, as well as reputational and brand damage. Here’s how we identify risks:
Assessment and monitoring
Analysts identify ESG risks during their bottom-up credit research. We analyse ESG risks through our own risk framework, which also takes into account Stranding Risk1, arriving at a customised ESG ranking. Analysts consider these issues alongside their own research with reference to a variety of other external sources.
By analysing and assessing ESG issues within a company, we can identify sources of unrecognised financial risk. We are able to identify companies with a higher default risk than the balance sheet implies. This gives us greater insight than that offered by a rating from a traditional credit agency.
A key output of the credit research process is the internal credit rating (ICR). The ICR is a forward looking measure of default risk over a 1-3 year time frame. Our ICR is on the same scale as ratings assigned by major ratings agencies, but can be materially different for individual issuers.
Our key engagement is with banks and counterparties to understand their ESG risks and their approach to managing those risks. For example, we are interested in understanding climate change and other environmental risks relating to a bank's loan book and financing, and aspects of their lending policies.
A challenge for responsible credit investors has been effective ESG engagement with issuers. This is in part due to the contractual nature of bond investments and the fact that a majority of securities are purchased on secondary markets. We do, however, actively incorporate ESG questions into our regular investor updates with issuers. Our brokers are aware of our ESG focus and also facilitate ESG discussions where possible. We continue to build on this program of engagement.