With climate change rising up the agenda, and trustees now required to consider core financial risks relating to environmental, social and governance (ESG) considerations, several defined contribution (DC) schemes have incorporated strategies with an ESG dimension in their default funds. The current pandemic, and the associated financial-market volatility and economic damage, has also served to highlight how companies with stronger governance and more sustainable business models can be better placed to withstand unforeseen events.

Much of the growing interest in responsible investing has focused on equities, but investors have more recently begun to appreciate how such an approach can also be applied to fixed income. ESG investing clearly differs between fixed income and equities, given that bondholders do not get to vote on corporate policy, while downside risk mitigation is more important for fixed income (bonds have limited upside, but similar downside risk to equities). In addition, bondholders have a variety of relevant ESG-themed areas available for investment that are not available to equity investors, such as green financing, universities, development agencies and social housing.

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Debt investors can also invest in private companies. When engaging with issuers that have weaker credit ratings and/or are private (especially in the high-yield sector where bondholders often provide a company’s only access to capital), we find that our questions, views and recommendations on ESG issues are increasingly being heard, which provides a real chance of effecting positive change.

ESG considerations are highly relevant when assessing sovereign bonds too, as such factors can affect a government’s ability to pay its debt obligations. ESG risks can include social considerations such as demographics and education levels, environmental factors reflecting the physical conditions under which a government operates, and, most significantly, issues related to governance: respect for the rule of law is a key indicator of willingness to pay, and a weak legal framework typically results in lower investment and economic growth.

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Because ESG considerations can have a material impact on credit risk (and therefore performance), integrating them into fixed-income analysis should, if done with diligence and consistency, result in superior risk-adjusted returns, as well as helping to influence responsible corporate behaviour and better societal outcomes. In today’s world, demand for fixed-income strategies with a focus on ESG considerations is only likely to grow, and it will be important for schemes and asset managers to reflect this, through a credible investment process, at all stages of members’ retirement journeys.

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