Our ESG philosophy for short-duration investing
Environmental, social, and governance risks have always been key considerations in our research and investment process. These factors are particularly critical given the core objectives of a short-duration portfolio: to maximize liquidity and preserve capital while achieving attractive total return.
Importantly, adverse ESG factors increase the risks of credit deterioration and illiquidity. We believe that there are areas where these risks are not currently compensated by valuations. In our view, heightened global scrutiny of issuers from an ESG lens will eventually drive up the cost of capital for many issuers with outsized ESG risks. In addition, we think it will potentially lead to lower liquidity in their bonds as more investors avoid these issuers. As an example, the tobacco sector already has a higher cost of debt and less demand for issuers on average versus other sectors for equal-maturity bonds.
We think in-depth, issuer-by-issuer, bottom-up analysis is required to appropriately identify ESG risks, especially as the above outcomes become more common. Our deep bench of ESG, climate, and credit analysts makes us well-situated to integrate this holistic understanding of risk into short-duration investments.
How we integrate ESG
As we consider short-duration investments, we incorporate ESG risk factors throughout our process, starting with our research inputs all the way through to portfolio construction and risk monitoring.
Our dedicated ESG analysts conduct proprietary research with a focus on material ESG factors that are specific to each sector. We engage with over 15,000 issuers every year to better understand ESG factors and advise issuers on material risks and paths toward improvement. Our key objective with engagement is to help debt issuers lower their ESG-related risks in the future and to improve the investment profile of their bonds to maintain their access to capital.
Our ESG Research Team develops in-house ratings so that portfolio managers can efficiently make investment decisions that incorporate our proprietary ESG research in real time. As a second layer of ESG integration depth, credit research analysts also incorporate findings from ESG research into their recommendations, so that the credit views that reach our portfolio managers already consider qualitative and quantitative ESG insights.
These combined efforts allow our investors to evaluate ESG risks both at the time of investment and as they monitor risks on an ongoing basis.
Three actionable ideas for clients to consider for enhanced ESG integration
We believe the three actionable ideas outlined below can potentially help you achieve the specific ESG-related short-term goals that you may have as an institution, while also supporting the overall, long-term goals of limiting the risks of credit deterioration and illiquidity.
1. Target greater environmental responsibility and a lower carbon footprint
How? Consider eliminating and restricting all issuers deriving more than 10% of revenue from thermal coal mining, 20% of revenue from thermal coal power generation, or 10% of revenue from oil sands.
The parallel benefit of these rules may be a significant reduction of carbon emissions attributable to the portfolio. With this solution, our research showed that the carbon footprint of a portfolio declined by 15% while only restricting about 1% of portfolio holdings. This can create an asymmetric benefit of carbon reduction with limited impact on the opportunity set for your portfolio manager.
2. Aim to achieve an improved portfolio ESG score
How? Consider eliminating and restricting all issuers that receive a 5 rating from our ESG Research Team.
This explicit implementation method fits naturally with a robust ESG integration process. We analyze issuers individually using a broad research process, as we think third-party inputs into scoring can be stale or incorrect. In our view, eliminating 5-rated issuers can help to mitigate overall portfolio credit risk and liquidity concern in the future, while also delivering immediate impact through a better weighted-average ESG score for the portfolio.
3. Seek to construct a portfolio with social responsibility as a focus
How? Consider eliminating and restricting all tobacco producers, issuers with ties to controversial weapons, and issuers that “fail” the United Nations Global Compact Principles.
We find that social restrictions tend to be unique to each client and in line with their own values and beliefs. Accordingly, we would seek to align social-related restrictions in a portfolio to meet those specific objectives.
We believe short-duration investors should consider material portfolio risks holistically, which requires appropriate integration of ESG considerations. Increasingly, we believe that ESG-related risks will impact credit fundamentals and issuer liquidity. In our view, investors should aim to be sufficiently compensated for any such risks to which they are exposed and avoid any risks that are outsized relative to their return potential.