Integrating ESG into credit research
By Samuel Lopez Briceno and Ethan Swartz, senior analysts in Vanguard's Fixed Income Group
Environmental, social, and governance (ESG) considerations have risen up the agenda of many investors in recent years1, not least as high-profile cases of ESG risks having a major impact on both corporates and investors have made the headlines.
But this growth in awareness has been accompanied by some confusion around how investment managers integrate ESG into their investment process. This confusion is understandable, given that ESG taxonomy, transparency and measurement standardisation are still evolving2.
A common misconception is that ESG integration is the preserve of equity fund managers. However, as we will see, incorporating ESG considerations is very much part of Vanguard’s fixed income credit analysis approach too.
Assessing ESG risk
First of all, it is important to distinguish between ESG integration and exclusionary screening. With ESG integration, no investment in the universe is off-limits based on the level of ESG risk alone. When we—as credit analysts—think about integrating ESG into our investment recommendations, our aim is twofold: to quantify the financial materiality of the ESG risk, as well as to assess whether the market price adequately reflects the risk. This is distinct from exclusionary screening, which precludes certain investments based on specific ESG-related criteria.
ESG risks are often realised over the long term and are therefore important considerations for fixed income investors that are expecting repayment at maturity along with modest coupon payments along the way. ESG risk is one of the core elements that make up our bottom-up, fundamental view of a company, alongside other factors that can impact our view on credit trend and event risk. Our internal credit research group assesses these risks at the sector and individual issuer level and combines them with a risk-adjusted relative value opinion to determine the investment recommendation.
Assigning ESG ratings
Vanguard assigns each credit an ESG risk rating of low, medium or high based on our assessment of the probability of an ESG event and the potential magnitude of its impact on the issuer’s credit profile. We take the ESG risk of any parent companies that could impact debt issuers into consideration too.
We also integrate ESG into our sector-level analysis, highlighting the key ESG risk factors facing each sector. This periodic review helps us understand how prevalent different ESG risk factors are across different sectors and allows us to focus on developing impactful subject matter expertise. For example, some sectors might be acutely exposed to environmental risks such as carbon use, greenhouse gas emissions or water usage, while others might face greater risks from social factors.
ESG driving change in credit sectors
ESG considerations are impacting issuers across the entire spectrum of the credit universe. However, the impact can be more profound for some sectors than others.
For example, following the Volkswagen diesel emissions scandal in 2015, the European automotive sector has faced increasingly stringent regulations—not to mention social pressure— to reduce air pollution from vehicles. As a result, car manufacturers have had to increase their research and development budgets, leading to higher capital expenditure and squeezed profit margins.
Add to this the Covid-19 pandemic and the resulting global recession, as well as the ongoing rise of electric vehicles, and you have a sector facing significant transformation.
Another case in point is the US healthcare distribution sector, for which an important credit driver is the pending settlement of claims linked to the US opioid epidemic. We believe that these settlements and trial outcomes have the potential to make a significant impact on the future cash flows of the companies involved; what’s more, some issuers will be better equipped to weather this impact than others, based on both financial strength as well as management actions.
Our approach to integrating ESG into our credit research process allows us to understand which companies are best positioned to navigate these issues and become the most likely to thrive in the medium to long term.
ESG integration and Vanguard bond funds
ESG integration is not only used by the analysts and portfolio managers of our actively managed bond funds. It also plays a part in the way we manage our fixed income index funds.
The constituents of fixed income benchmarks are determined by index providers, which may or may not take into account ESG risks. However, owing to the huge size of many bond indices, as well as the fact that many bonds are not available for purchase, it is often not practical for index funds to buy every bond in the index.
Vanguard uses a sampling replication approach for most of its bond index funds. The sample aims to match the characteristics of the index and track its returns, without necessarily buying all the securities in the index. This allows us to achieve the optimal trade-off between cost and tracking.
As our credit view (which integrates ESG risks) is one of the components of our sampling process, this can impact the position sizes in our bond index funds.
For our active fixed income funds, we consider ESG an additional risk that needs to be reviewed and integrated into each security’s valuation. When an opportunity presents itself, our active fund managers have discretion around whether to own the bond or not.
Engaging with companies on ESG
There are other ways we integrate ESG into our investment process. One is through direct engagement with companies. Our credit research analysts regularly speak with company management teams to discuss a wide range of issues that might pose them financial or reputational risk, including—but not limited to—ESG risk.
The goal of this engagement is to drive improved disclosure and reporting from the companies we invest in. We work closely with Vanguard’s Investment Stewardship team, which leads Vanguard’s engagement with corporate boards and executive teams. Investment Stewardship also engages on ESG risk, especially as it relates to long-term value and proxy voting for internally managed equity holdings.
Challenges – but also opportunities
There are challenges in integrating ESG into credit research. One hurdle we face is that the data to help us identify ESG risks is not always readily available. However, we work with a number of third-party providers to get all the inputs we need to make an informed assessment. And the provision of ESG risk data by corporates is improving all the time.
What’s more, you can view ESG integration through a positive lens. After all, every ESG risk we identify carries with it the seed of an associated opportunity. To a corporate, an ESG risk might be seen as a potential threat; to us, it could also offer the prospect of attractive long-term risk-adjusted returns for our investors.
Our fiduciary duty means that our investment decisions should not be driven by a given set of values or personal beliefs. As active credit analysts, our job is to assess the risks and—where possible—take advantage of the mispricings when we differ from the market consensus.
1 According to Global Sustainable Investment Alliance (GSIA), the global assets in ESG screened strategies more than doubled from $12.3 trillion in 2012 to $26.3 trillion in 2018.
2 Source: Aggregate Confusion: The Divergence of ESG Ratings; Berg, Koelbel and Rigobon (2019).
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