Environmental, social, and corporate governance – a fixed income game changer

Momentum’s head of fixed income, Ian Scott, is sure that environmental, social, and corporate governance (ESG) is a “game changer for fixed income”.

However, there is still a lot to learn about how to incorporate ESG considerations pragmatically into a fixed income portfolio.

“Our credit process is where ESG will have the most relevance,” said Scott, who co-manages the Momentum Bond fund.

“If you think about a credit process, we have to assess the fundamentals of a corporate or SOE (state-owned enterprise). Firstly, is it a good business? Secondly, does it have a good management team? And, thirdly, is it a profitable business? Can it actually pay our coupons?”

The challenge is working out how to evaluate the interplay between ESG considerations and these fundamentals.

“In the fixed income industry, we like to quantify things – attribute them and give them a score,” said Scott.

“Once we have a score, we can assess the price and whether we are being rewarded for the risk we are taking.”

The question is how ESG fits into this kind of framework. Can an ESG analysis be used in the same way as a credit rating, for instance?

“When credit ratings started, people looked at them and asked: ‘what do these actually mean?’,” said Scott.

“Today, we live in a world where we couldn’t live without ratings.

“Is this the path we are going to follow with ESG as well? At the moment, we can get an ESG score for an issuer, but what does that score mean? And what does it mean for our investments. Do fundamentals override ESG?”

This is the kind of debate that credit teams are currently having.

“If we have a company with great fundamental scores and great credit scores, but low ESG, will that rule it out?” said Scott.

“Or do we say the fundamentals are more important because we as fixed income investors have to make sure we are getting our clients’ money and our coupons back, even if we are investing in a company with a low ESG score?

“Similarly, can we look at a company and say the credit quality is so-so, but it has a great ESG score and because we should go ESG we’ll just do it?”

Scott added out that there is a need to be pragmatic in this area. He pointed out that it is possible, for instance, to make a sound case for investing in carbon-intensive companies.

“For example, we will invest with Exxaro on the proviso that there is a path or transition to clean energy,” said Scott.

“We will not do dirty coal anymore, but we can’t just take the coal industry away. So, we’ll say we’ll invest and walk this path with you.”

He added that, while incorporating ESG means that there is another layer of scrutiny applied for investors, it can’t simply supersede everything else.

“We support ESG, but we will not support false ESG,” said Scott.

“We have seen entities in South Africa issue green bonds that are not really green. And we have seen other entities issue green bonds at very expensive prices, just because they are green.

“As value investors, we won’t just pay any price for an ESG bond. We will support it if it makes sense on a risk-adjusted basis to have it in our portfolios.”

Patrick Cairns is South Africa editor at Citywire