For those investors playing the long game, Environmental, Social, and Governance (ESG) investing is not a fad. Rather, ESG considerations are now an integral part of any forward-thinking investment process. This is particularly true in a competitive fixed income environment where it’s vital to identify relative value and capture incremental yield.

In a world where numbers reign supreme, it’s ironic that examining the non-financial ESG pillars has become so important. But, simply put, ignoring or otherwise getting ESG considerations wrong can lead to holding securities with falling valuations, rather than those with better prospects and steady-to-rising valuations.

Fixed income analysts have long used credit ratings as the key component of the investment process since they directly address an issuer’s ability to repay obligations in full and on time. That’s the heart of a credit rating, and it’s no secret why that’s important to bond investors. But what if an investor went the extra mile and used the same discipline to evaluate issuers of securities on an array of ESG criteria?

For example, after rigorous credit analysis, an investor might dig into some quantitative factors in the Environmental pillar, such as greenhouse gas emissions or water withdrawal figures (particularly in regions of scarcity). Environmental qualitative factors might include an evaluation of the probability of meeting greenhouse gas emissions targets or the quality of the issuer’s water usage policy. An investor might also want to evaluate the Social pillar, examining elements such as the issuer’s safety record and the diversity of its management, as well as any stated targets towards improving these areas. Lastly, on Governance, an investor should look at the inclusiveness of the issuer’s leadership and its corporate behavior and ethics. All these may be non-financial metrics, but they matter for investors. 

Moreover, when it comes to comparing securities, issuers may boast similar financial metrics, but they may have very different ESG scores. That difference can have a meaningful impact when it comes to determining the true risks associated with that security. This point may seem subtle, but, it could turn out to be significant over the long run.

Of course, it is a significant effort to develop a comprehensive array of ESG metrics and maintain scores on each issuer. It would be far easier to do it perfunctorily or simply to purchase scores from a third-party provider. However, we believe that developing and maintaining an ESG framework is a significant distinction among fixed income managers. Ultimately, we think that scoring every bond in a portfolio based on ESG characteristics as they relate to an issuer’s creditworthiness will lead to better investment choices.  

Best practices in fixed income investment management now require an evaluation of an issuers’ ESG characteristics. Be certain your fixed income manager is going the extra mile.