by Jonathan Bailey, Head of ESG Investing, Neuberger Berman
ESG is relevant to bonds as well as equities, but in different ways.
Investors instinctively understand how weak corporate governance can be linked to poor financial performance. Whether it is wasting shareholder capital on expensive acquisitions, a board that is insufficiently independent to challenge a CEO’s failing strategy or an audit committee that lacks the expertise to ensure the accounts are a full and fair representation of the financial health of the company, the ways in which governance failures can damage the bottom line are many and various.
Yet the environmental and social aspects of ESG investing are just as linked to financial value creation—just think of the businesses that are building the sustainability solutions of the future.
Productivity growth has been the main driver of the economy in the post-war era; a manufacturer that produces an aircraft engine that uses less fuel per seat mile or a tech company that can automate and network analytical tasks to the cloud so that they can be processed by highly efficient data centers is creating dollars and cents for its customers and supporting broader economic growth.
Patterns of demand are shifting, too. Consumers increasingly want to know that their cell phone was made in a supply chain that protects worker safety, or that their morning coffee is served by a company that actively embraces diversity in its workforce.
Companies don’t invent highly efficient new products, audit their supply chains or introduce a culture of inclusion overnight. It might take several years for these efforts to bear fruit—but once built, they may form sustainable competitive advantages.
This may be part of the reason why ESG investing has historically been most robust among public equity investors—they can identify management teams who are taking these steps early, invest with a long-term perspective and participate in the potential upside.
Fixed income investors, concerned to get their coupons and principal over the next couple of years, might feel they needn’t worry about these factors. Perhaps they would argue that it’s enough to consider the governance of the issuer to ensure that capital allocation will be disciplined, the board will be independent and their claim on the cash flows will be protected.
Perhaps. But more and more fixed income investors are re-thinking these assumptions. Investors in sovereign debt have been innovators in understanding the importance of environmental and social indicators and their correlation to the ability of a sovereign to service their debt. Now more corporate fixed income and credit teams are taking these factors into account, changing the sort of ESG data that companies are being asked to disclose.
Think about that cloud computing company that is bringing more and more data onto its highly efficient servers. Certainly confidence in the likelihood of growing free cash flows is relevant to the fixed income investor, but they will also want to ask other questions. How is data privacy and cybersecurity being handled? Would a significant public attack undermine customers’ willingness to continue placing data onto the cloud? What if regulators in one region impose stricter data sovereignty rules requiring the company physically to relocate its data centers?
These risks could materialize suddenly, blowing out credit spreads or, in a worst-case scenario, jeopardizing the ability to pay back corporate bondholders.