Loud and Clear
Bondholders are increasingly engaging with both corporates and sovereigns to address systemic risks.
Shareholders are often seen as having the upper hand in engagement and stewardship, but increasingly bondholders are finding their own voice. They are employing a different toolkit individually as well as collectively to change the direction of issuers should they veer off the sustainable course.
With notable exceptions, bond investors have been regarded as paying less attention to ESG issues than their equity counterparts. Over the course of this decade, however, regulations such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and wider adoption of frameworks like the UN Sustainable Development Goals (SDGs) have been an impetus.
Fixed income investors are also realising the size of the market gives them clout. The latest figures from the Securities Industry and Financial Markets Association show that the global bond market was worth US$140.7 trillion in 2023, spanning across corporates as well as sovereigns and supranationals. By contrast, the equity equivalent was valued at US$111 trillion.
Although there are various tranches and instruments, research from RBC BlueBay Asset Management notes it can be easier to engage with investment-grade issuers than their high-yield counterparts. This is due to the typically large size and resources of the issuer and its appetite to engage on a wide range of topics. However, high-yield discussions can generate insights as well as a better comprehension of ESG practices and risk management, particularly when there is a lack of third-party data.
My-Linh Ngo, Impact-aligned Strategist in the Responsible Investment (RI) team at RBC GAM, notes that overall engagement in fixed income is skewed more towards management of risks and capital preservation than equities, where the latter is more likely to also assess growth opportunities.
“This is because the upside is capped for bondholders but not so their downside, “she says. “There is a misconception that equity investors have greater influence because of their ownership and proxy voting rights, but this is not the case. Bondholders just have different rights, and levers for engagement.”
The right to engage
Sophie Demaré, Sustainability Investment Analyst for Fixed Income at Federated Hermes, echoes these sentiments. “The concept that bondholder engagement is new and vastly different to equity engagement is outdated,” she says. “Bond and shareholders have the right to engage because both are financial stakeholders. The difference is that while a shareholder’s right comes from being a part-owner, the rights of a bondholder are as a recurring source of cash, which companies need to thrive.”
Unsurprisingly, fund managers have their own style, but the starting point for all is the research process. “Credit and ESG analysis form the foundation of our engagement,” says Ngo. “It is important to do your homework and gather information about whether the company and bond is an attractive investment with attractive risk-adjusted, long-term returns. Considering ESG risks can help inform that.”
For Anne Scott, Global Climate Solutions Lead at Aegon Asset Management, there are two main components – research assessment and action. Focusing on climate, the first stage involves a careful analysis of the company’s net zero transition plan and whether it is meeting its targets as verified by a third-party agency such as Science-Based Targets initiative, a voluntary climate programme that confirms emission reduction pledges.
Aegon then rates companies on a five-tier scale, from laggard to leader, with engagement prioritised towards those companies at the lower range. “It’s our assessment outputs which really support our engagement conversations,” she says. “Engagement is often about encouraging better disclosure and improving understanding.”
Mutually beneficial dialogue
Sovereigns are also put through their paces. As a 2023 paper by JP Morgan Asset Management notes, engagement can be more nuanced compared to the corporate market, depending on the political complexion of the country. It could take the form of meetings or writing to government officials regularly to review, for example, the climate risks that could have a financially material impact on portfolios.
Thomas Dillon, Head of Sovereign ESG at Aviva Investors, says the firm starts a dialogue with governments – the counterparties to sovereign bond investments – in order to gather information and promote sustainable practices. “We want to understand the issues and offer an investor perspective on how sustainability risks could be mitigated,” he says. “We are finding policymakers are very willing to engage and they recognise that dialogue with investors can be mutually beneficial.”
Increasingly, the rationale for corporate and sovereign engagement are intertwined. Dillon explains Aviva Investors has adopted a holistic approach to stewardship which goes beyond voting and individual company engagements, recognising that decisions are influenced by wider factors including the policy environment. This approach is often seen as necessary in the context of pressing systemic risks such as climate change. Dillon notes that, despite the introduction of carbon pricing in some countries, firms can still pollute without bearing the full cost of those emissions. If unaddressed, firms that set ambitious objectives and invest to reduce emissions might find themselves at a competitive disadvantage.
Dillon says this is a classic example of market failure, with one of the main ways to correct it being through policy action, where investor engagement with sovereign bond issuers can play a role.
Although climate is often centre stage, governance remains an important topic. “We see good governance as a requisite, though not a guarantee of, strong business performance, so it is a common engagement theme for us,” says Demaré. “Long term resilience is also predicated on the effective management of climate, environmental, and social risks, meaning that our engagement plans have a large overlap with our equity peers.”
Market participants are paying special attention to the transparency of covenants, transaction documents and use of proceeds. “To date, much of the climate-related protections in loan documents are tied to coupon rachets and we would like to see additional teeth put in the covenants,” says Matthew Christ, a Portfolio Manager in Ninety One’s fixed income team.
“While coupon ratchets have the benefit of linking key performance indicators with the cost of borrowing for a company, we can go a step further and make adherence with climate commitments a tested covenant and non-compliance could result in a loan default.”
Given the pressing nature of these issues, many fund managers initiate conversations with corporates and sovereigns during the roadshow conducted to market new issuance. As Rhona Cormack, Senior Stewardship Analyst at Insight Investment, notes, “It can be a high point of influence because many issuers are looking to drum up interest and we can then talk to them about whether they align our expectations, as investors.”
Thomas Coudert, Head of Sustainability, Core Investments at AXA Investment Managers, says discussions at roadshows have shifted focus, with more questions being asked today about ESG-related issues. “When issuers are first raising money, we are in a better position to push our ideas, as well as talk to the wider circle of banks and debt capital markets to adapt best practices,” he says. “The conversation also helps to gather information and glean insights, but it is important to remain vigilant because if companies do not need to refinance, they may not deliver or follow the ESG strategy. “
Patience a prerequisite
Bondholders also do not act alone. They often join forces with each other or shareholders and there are several initiatives to facilitate collective engagement. Ngo points to the Investor Policy Dialogue on Deforestation (IPDD), which was established in 2020 and supported by 81 financial institutions, from 21 countries, representing approximately US$10.5 trillion in assets under management. The aim is to show governments that investors see deforestation as a systemic risk that can impact the creditworthiness of a country or investment.
Patience is a prerequisite. RBC Bluebay, which is IPDD co-chair with Storebrand, has been leading the charge in Brazil to encourage policymakers at federal and state level to increase their efforts in tackling deforestation in the Amazon and other key biomes. Discussions and the prospects of progress, Ngo notes, have become easier and more promising since the election of Luis Inacio (Lula) da Silva as President in 2023, which has opened up the possibility of a meaningful shift away from the policies and rhetoric of the Bolsonaro administration.
The IPDD still has its work cut out to encourage faster progress towards the transparency and data-sharing that will enable greater scrutiny of supply chains and therefore better commercial incentives for the protection of forest cover. However, RBC BlueBay recognised the advances and revised its investment ESG score for Brazil as a sovereign issuer from -2 to +1 on a scale of -3 to +3 last year.
The initiative has also had success with Indonesia cutting its deforestation rates. In a report, the IPDD said that public policy has been a key contributor along with civil society and investor engagement, leading to companies and producers moving towards more sustainable production. Investors have recognised the country’s efforts in protecting its tropical forests and acknowledge the potential for growth in Indonesia. However, they would still want more information on plans to continue tackling deforestation as well as the broader nature-related risks and opportunities.
To this end, the IPDD is working with relevant government authorities and financial market regulators to promote sustainable practices and to reduce financial risks arising from deforestation and land degradation. Moreover, given tropical forests’ vital role in the country’s nationally determined contribution to the Paris Agreement, it is also supporting the government on meeting its climate targets.
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