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Royal London’s Fixed Income Team explain how they work
Our fixed income approach
Rocky recovery?
Jonathan Platt on fixed income strategies for troubled times
To be truly sustainable, funds need an active approach
The active ESG dimension
The ESG Observatory
How TwentyFour’s Observatory took on the ESG data challenge
ESG overlays and the danger of stifling performance
The sweet spot
ESG’s tipping point
Why fixed income can be key to pushing for positive change
hile ESG principles have been available in the fixed income asset class for decades, the process to invest sustainably is difficult, predominantly
due to a lack of data about bond issuers – with much of the bond universe still not publicly rated or analysed by research houses.
W
In this Spotlight, we explore how the data challenge not only pushed TwentyFour Asset Management to enhance its own Observatory platform to take ESG analysis in-house, but also to formalise its ESG process in order to integrate sustainable metrics across all its products.
This renewed focus on fixed income and sustainability represents a step-change for the industry, highlighting that the path to creating a sustainable bond strategy requires careful analysis of investors’ most important needs – performance, volatility, and engagement that elicits real change.
“There have been a number of bumps in the road to implementing an effective style of ESG investing in fixed income, but by meeting the data challenge and taking a truly active approach, we believe bond investors can make a real impact on corporate behaviour.”
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FIXED INCOME & ESG
For Professional Clients only
fixed income & ESG
hilst ESG principles have been available in the fixed income asset class for decades, the process to
invest sustainably is difficult, predominantly due to a lack of data about bond issues – with much of the universe not publicly rated or analysed by research houses. Until now.
Past performance is not reliable indicator of future performance. The value of investments and any income from them can fall as well as rise and investors may not get back the amount invested. Investing in fixed income securities comes with risks which will generally include credit risk, default risk, inflation risk and interest rate risk. Please refer to the respective offering documents for further details on the applicable risks. There is no guarantee that sustainability criteria will always be met for every investment and a negative impact on performance is possible where pursuing sustainable economic activity rather than a conventional investment policy. This is for marketing information and educational purposes only and should not be considered as investment research, investment advice or a recommendation of any particular security, strategy or investment product. Any views and opinions are those of the investment manager which are subject to change without notice and may have already been acted upon. No part of this material may be reproduced in any form without express written permission. TwentyFour Asset Management LLP is registered in England No. OC335015, and is authorised and regulated in the UK by the Financial Conduct Authority, FRN No. 481888. Registered Office: 8th Floor, The Monument Building, 11 Monument Street, London, EC3R 8AF. For further information visit the TwentyFour Asset Management website.
Crucially, we see why TwentyFour considers active management essential to an effective fixed income ESG strategy.
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“The ESG investment world is full of badges and individuals and firms that have signed up to different types of accreditation. The next thing will probably be the creation of global ESG ratings. But do any of these really reveal how ESG metrics are being implemented within the company itself?”
To create truly sustainable fixed income portfolios, Anderson thinks it is necessary to put in the work to gain a deep understanding of each individual company yourself.
This is in part because the data coming out of large corporations may look good on the face of it, since these firms “have teams and teams of marketing people and analysts” and can therefore “profile themselves very well on an ESG basis because they know the questions and the answers they should be giving,” says Anderson. Drilling down deeper, however, could - and often does - yield drastically different insights.
Against this backdrop, Anderson believes a hands-on approach to ESG fixed income is unavoidable. This includes both granular quantitative and qualitative research, positive/negative screening and regular engagement with issuers. This approach has helped TwentyFour create alpha in its sustainable portfolios relative to its peers.
This, however, is in the process of changing. Strong investor demand for better choice of ESG fixed income products has led to extensive research and data collection in the asset class. In 2021, the industry finds itself at a tipping point when it comes to investing in bonds sustainably.
the equity space, while the choice available to fixed income investors has been limited.
SG investing surged in popularity last year as the coronavirus pandemic shone a spotlight on a wide range of environmental, social and governance risks. However, both demand and product offering have until now clustered around
E
While third-party data availability is improving, TwentyFour’s view is that relying on these ratings alone for investment decisions is not good enough and cannot be considered true ESG investing.
Poor ratings
For Anderson the need to invest in ESG as a concept goes deeper than returns. Much like in the equity universe, engagement is a key tool for bond investors in trying to effect positive change. Far from having no voice when it comes to company resolutions, fixed income investors are in fact often in pole position when it comes to pushing for positive change. Most companies require regular debt refinancing and are therefore forced to turn to the bond market and come face-to-face with their capital providers multiple times a year.
Digging deeper
However, Anderson believes this engagement must be targeted and issue specific: “You have to engage where you think you can be effective. Ultimately, we want better societal outcomes. So if you come to the conclusion that you really believe a company is on a path to a better sustainable future, then capital markets should support that company, not shun it because of where it is today.”
In fact, according to Chris Bowie, also a partner and portfolio manager at the firm, in his experience the best-performing companies both in terms of alpha and ESG are likely to be those that score relatively poorly on ESG metrics today but are committed to positive change. Ultimately, you would expect them to see a fall in their cost of capital, which would lead to a capital gain from their bonds.
Positive momentum
“One of the best examples is Scottish and Southern. Five years ago, most of their electricity came from coal. In 2020 they exited coal for good. So they have really cleaned up their operation”
In addition, Anderson says engagement has been effective in driving better reporting from issuers. For example, more and more issuers are reporting CO₂ intensity data, having realised this is important for their investors.
As reporting standards and data improve, ESG investing in fixed income clearly looks to only be going in one direction. But as demand grows, so do investors’ expectations. As such, both Bowie and Anderson say a sophisticated and thorough approach will be paramount for those wanting to stay in the game.
The most material impact of this demand will be at a fund management level, says Anderson, though he notes issuers are also becoming more proactive: “We have now got two sustainable funds at TwentyFour and it is clear that interest from asset owners is growing rapidly, and this reflects their increased understanding of the nuances of a sustainable fund.
“From the issuers’ point of view, they are receiving more ESG-focused questions from us and they can no longer avoid them. We have seen a growing number of issuers stating that if we can provide a premium on a bond issue, they will link capital to green projects or a commitment to cutting CO2 emissions over time. If they fail, there will be a step-up on the coupon.”
Fixed income investors are in "pole position to push for change" when it comes to ESG
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Sophisticated investors, especially pension funds, are already putting more emphasis on detailed reporting of ESG and sustainability metrics and showing more interest in fully sustainable funds over pure ESG integration models, and Anderson expects this trend to grow.
Reporting demand and expectations will increase
Anderson expects ESG data availability in fixed income to improve over time, with stricter standards and definitions being introduced. However, he warns against over-reliance on industry ratings and “badges”, which are in danger of being a simple box-ticking exercise.
ESG data will improve
While the US has traditionally lagged behind Europe in ESG and sustainable investing, Anderson sees this changing and believes the change could be “huge”. A big driver for this has been the election of Joe Biden as US President, who has already signalled his commitment to the ESG agenda by rejoining the Paris Agreement.
ESG investing will take off in the US
The green bond market reported annual growth of 49% in 2019, and Anderson expects this trend to continue as demand for green, sustainable and social bonds grows. However, he highlights that in his view the regulation and monitoring of this space so far has been inadequate, while the low levels of yield these bonds tend to offer often fail to make them an attractive investment at this stage.
Expect to see more green and social bonds
As demand for companies with the highest ESG scores reaches a tipping point, Anderson predicts some ‘sin’ industries, such as tobacco and alcohol, could reach a tipping point where they become cheap enough to compensate investors for taking on ESG risks. While a sustainable fund may not be able to take advantage of this, ESG-integrated vehicles likely could. He also sees companies in these industries potentially exiting public markets and looking for funding in private markets, as investors increasingly shun funds with exposure to ‘sin’ industries.
‘Sin’ industries become cheaper
Five predictions for ESG fixed income
One of the biggest issues is that fixed income investors do not get a seat at company AGMs, and are therefore unable to vote. At the same time, the availability of data in the fixed income space is much less transparent than in equities; it is estimated that at least a third of the bond investment universe is not currently covered by publicly available data.
While being challenging, true ESG investing in this asset class is by no means impossible and does not have to be more difficult than in the stock market, according to Graeme Anderson, partner and portfolio manager
at TwentyFour Asset Management. The key, he says, is to have the right building blocks, meaning the underlying data and research to inform investment decisions.
This data is constantly improving and has benefitted from the adoption of a formalised approach that drills down deeper into ESG issues. Anderson points out that some form of ESG consideration has been inherent in fixed income investing for decades, particularly on the governance side.
“The big change that we have seen is that we are now conducting more formal analysis of ESG,” he says. “Formalising it has made it much more powerful and it is spreading out to look at more environmental and social issues.”
The road to this point has been bumpy, with a number of stumbling blocks making it harder to implement a ‘true’ style of ESG investing in the fixed income space.
building blocks
The ESG investment world is full of badges and individuals and firms that have signed up to different types of accreditation. The next thing will probably be the creation of global ESG ratings.
One of the best examples is Scottish and Southern. Five years ago, most of their electricity came from coal. In 2020 they exited coal for good. So they have really cleaned up their operation.
One of the biggest issues is that fixed income investors do not get a seat at company AGMs, and therefore are unable to vote. At the same time, the availability of data in the fixed income space is much less transparent than equities, with it estimated that at least a third of the bond investment universe not currently covered by publicly available data.
However, while being challenging, true ESG investing in this asset class is by no means impossible and does not have to be more difficult than equities, according to Graeme Anderson, partner and portfolio manager at TwentyFour Asset Management. The key, he says, is to have the right building blocks, meaning the underlying data and research to inform investment decisions.
This data is constantly improving and benefiting from the adoption of a formalised approach that drills down deeper into ESG issues. Anderson points out that some form of ESG consideration has been inherent in fixed income investing for decades, particularly on the governance side.
“The big change that we have seen is that we are now making more formal analysis of ESG,” he says. “Formalising it has made it much more powerful and it is spreading out to look at more environmental and social issues.”
This, however, is in the process of changing. Strong investor demand for better choice of ESG fixed income products has led to extensive research and data collection in this space. In 2021, the industry finds itself at a tipping point when it comes to investing in bonds sustainably.
and governance risks. However, both demand and product offering have until now clustered around the equity space, while the choice available to fixed income investors has been limited.
SG investing jumped in popularity last year as the coronavirus pandemic shone a spotlight on a wide range of environmental, social
This is in part because the data coming out of large corporations may look good on the face of it, since these firms “have got teams and teams of marketing people and analysts” and can therefore “profile themselves very well on an ESG basis because they know the questions and the answers they should be giving”, says Anderson. Drilling down deeper, however, could - and often does - yield drastically different insights.
Against this backdrop, Anderson believes a hands-on approach to ESG fixed income is unavoidable. This includes both granular quantitative and qualitative research, positive/negative screening and in-house and regular engagement with issuers. This approach has helped TwentyFour to create alpha in their sustainable portfolios relative to its peers.
While third-party data availability is improving, TwentyFour’s view is that relying on these ratings alone for investment decisions is “not good enough” and cannot be considered true ESG investing.
For Anderson the need to invest in ESG as a concept goes deeper than returns. Much like in the equity universe, engagement is a key tool for bond investors in trying to effect positive change. Far from having no voice when it comes to company resolutions, fixed income investors are in fact often in pole position when it comes to pushing for positive change, since most companies regularly require debt refinancing and are therefore forced to turn to the bond market.
As reporting standards and data improve, ESG investing in fixed income clearly looks to only be going in one direction. But as demand grows, so do investors’ expectations. As such both think a sophisticated and thorough approach will be paramount for those wanting to stay in the game.
The most material impact of this demand will be at a fund management level, says Anderson, although he notes issuers are also becoming more proactive: “We have now got two sustainable funds at TwentyFour, and it is already clear that the interest from asset owners is growing rapidly and reflects the fact their understanding of the nuances of a sustainable fund have increased.
“But from the issuers point of view, they are receiving more ESG-focused questions from us and they can no longer avoid them. We have seen growth in issuers stating that if we can provide a premium on a bond issue, they will link capital to green projects, or a commitment to cutting CO2 emissions over time. If they fail, there will be a step-up on the coupon.”
“One of the best examples is Scottish and Southern,” Bowie says. “Five years ago, most of their electricity came from coal; in 2020 they exited coal for good. So they have really cleaned up their operation.”
A large part of the research work had to be conducted in-house. It was a process that ended up taking several years, thousands of hours of research and the complete overhaul of a tool unique to TwentyFour – a proprietary relative value system named Observatory.
The team began by accessing an ESG database created by Research Financial, called Asset4, which allowed the firm to integrate ESG factors across all of its investment decisions. However, they didn’t think this alone was enough to build a truly sustainable bond fund. The third-party database did not cover around 40% of the firm’s investment universe.
This was the challenge facing Chris Bowie, partner and portfolio manager at TwentyFour Asset Management, when he decided ESG could and should be part of the firm’s investment process.
managers is exacerbated by the complexity of a bond’s structure, consisting of multiple parts which must all be individually assessed.
reating a truly sustainable bond fund is no mean feat. Unlike the listed equity universe, where ESG data is more readily available, it is often sorely lacking in the fixed income space. At the same time, the problem for fixed income
C
“We first convened a steering group and met every month for two years to decide on what we thought was the best way to combine ESG metrics with our strategies,” explains Bowie, who had been struck by studies as far back as 2017 which had started to show for the first time how environmental factors were becoming correlated to the future performance of credit. “It led to us deciding after a year that we were going to need to change our investment process and create our own research processes to identify sustainable parts of businesses.”
The group’s Observatory platform combines data from Asset4 and uses the team’s own extensive in-house ESG research to fill in the gaps. The end product is a database which scores every company in the universe from 0 to 100 based on a range of quantitative and qualitative ESG metrics.
A gaping data hole has meant fixed income is often left behind in terms of ESG, with much of the universe unrated
This approach resulted from rigorous quantitative testing, which applied various negative and positive exclusionary screens to the firm’s existing Absolute Return Credit fund to determine what the return profile of the fund would have been were TwentyFour to have turned it into a sustainable product.
At first, Bowie applied a negative screen to the portfolio, meaning certain sectors such as tobacco and alcohol were excluded. The results of this were not encouraging: the fund would have lost around 1% a year in terms of performance, which is substantial for a bond fund, while volatility would have increased.
The approach to ESG for Bowie and TwentyFour was twofold: ESG integration across all of its strategies as well as focusing on launching a number of sustainability-focused bond funds. The difference between the two is significant, as it is only within the sustainable fund range that the firm applies a careful combination of negative and positive screening to create a product that they believe can offer a similar level of risk-adjusted returns to its non-ESG counterparts.
The fund comparison
However, applying a positive screen in combination with a negative screen yielded much better results. In fact, it showed that the best performing part of the portfolio would have been securities with the highest ESG scores.
“We found the magic number for us is 34 for the minimum ESG score,” says Bowie. “This is where the research determined you get the best balance of ESG impacting your returns without dramatically increasing your volatility.”
It was also illustrative of the fact, notes Bowie, that a sustainable fixed income fund is not a “free lunch”. 34 as a minimum figure may seem like it is too low to include in an ESG fund to some. It also excludes almost half of the group’s credit universe from the positive screen. But Bowie argues it is important to recognise ESG strategies will not work for every type of fund.
The answer, according to Bowie, lay in finding the sweet spot where risk, return and ESG credentials meet. To find this, the team compared the performance and volatility metrics of a range of portfolios applying increasingly stringent positive screens with combined ESG scores from 10 to 80 (the latter meaning only companies with a combined ESG score of 80/100 and higher would be included).
Sweet spot
“With an ESG process as detailed and as engaged as ours, you cannot access traditionally defensive sectors, so you can’t realistically have a lower level of volatility that many investors might be used to,” he explains. “This is why we are adamant that we need to offer choice. For some investors, it is all about the sustainable focus. But others need risk-adjusted returns, and for them ESG integration in our traditional funds is enough.”
According to Bowie, the main difference between the group’s core sustainable funds and integration is that ESG integration “doesn't stop [the managers] buying companies that might have relatively poor ESG scores”, though when investing in riskier companies from an ESG standpoint “you need to be compensated by being paid a much higher yield for these investments”.
This is why he thinks the sustainable portfolios TwentyFour creates are unique in the fixed income fund market. By finding a similar risk-return combination to its other products, the firm can offer its clients the choice between ESG integration, which underpins all of its funds, and the more rigorous screening approach applied to its sustainable range.
Integration means the group considers ESG factors as part of its relative value decision alongside traditional methods of credit analysis. Every portfolio manager has to integrate ESG factors into their decisions and it helps form assessments of relative value. From there the managers determine the yield they require from the potential investment to accept those additional ESG risks. If the company looks risky in terms of ESG factors, the yield needs to be higher.
integration versus sustainable
The concept of engagement is built into the group’s Observatory platform. All of the data is supplemented with a momentum score which is an assessment of how well a company is improving its ESG credentials. The managers are looking for companies on a positive trend and Bowie refers to this score as the ‘delta’.
“We do not get to vote but we can influence behaviour through our engagement. We share this with our clients and publish reports about our engagement meetings on our website quarterly, because we understand transparency is key to inciting change”
The final element of the firm’s ESG policy is ongoing engagement with issuers to try to help the businesses improve their ESG credentials. The results of these engagements are published on TwentyFour’s website on a quarterly basis, ensuring transparency and accountability for the portfolio management team.
The engagement possibilities
This assessment helps focus engagement as well. “We do not get to vote but we can influence behaviour through our engagement. We share this with our clients and publish reports about our engagement meetings on our website quarterly, because we understand transparency is key to inciting change.”
The group has also written about company practices through its blog in order to challenge decisions that reflect badly in ESG terms. For example, in 2018, Aviva announced it was going to cancel its preference notes at par, with large losses for mainly retail holders.
“We find it helps to get comfortable with a company that's moving in the right direction, then you can look to invest in all of their bonds and enjoy the benefit of that company becoming cleaner and greener.”
“We saw this as an example of treating stakeholders poorly, and differently. It gave us concerns about their willingness to call subordinated debt at future call dates,” says Bowie, who at the time reached out to the issuer’s finance and investor relations teams. “But we also realised we have the power of our blog; and within one week of publishing our concerns we were pleased to see Aviva had reversed its position.”
Where is the ESG fixed income sweet spot?
How do you ensure your ESG overlay is not stifling performance and volatility?
Why integration?
More accuracy on relative value
Deciphering fund performance and volatility with ESG overlays
Plugging the data hole
Total inclusion of all managers
Formalised assessment on ESG
Flexibility to invest in poorly rated bonds – if the yield fits
The database has colour-coded markers to denote strong (green), middling (white), and poor (red) ESG performance. Controversy and raw scores are assessed too. In this example, a good raw score is hurt by controversies, resulting in an average combined score
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Bowie attributes this to the defensive characteristics of bonds in many of these ‘sin’ sectors, despite the companies’ exposure to ESG risks down the line.
The only problem? Just 28 bonds qualified for the highest scoring category, while the volatility of this model portfolio was off the acceptable scale.
A company that scores relatively poorly today but has a board that has committed to change means that its momentum score would reflect the fact the future for this business should be better.
A large part of the research work had to be conducted in-house. It was a process that ended up taking several years, thousands of hours of research and the creation of a unique tool – a proprietary relative value system named Observatory.
The group’s Observatory platform combines data from Asset4 and uses the team’s own extensive in-house research to fill in the gaps. The end product is a database which scores every company in the universe from 0 to 100 based on a range of quantitative and qualitative ESG metrics.
This was the challenge facing Chris Bowie, partner, and portfolio manager at TwentyFour Asset Management, when he decided ESG can and should be part of the firm’s investment process.
“We first convened a steering group and met every month for two years to decide on what we thought was the best way to combine ESG metrics with our strategies,” explains Bowie, who had been taken in by studies as far back as 2017 which had started to show for the first time how environmental factors were starting to become correlated to the future performance of credit. “It led to us deciding after a year that we were going to need to change our investment process and create our own research processes to identify sustainable parts of businesses.”
is often sorely lacking in the fixed income space. At the same time, the problem for fixed income managers is exacerbated by the complexity of a bond’s structure, consisting of multiple parts which must all be individually assessed.
reating a truly sustainable bond fund is no mean feat. Unlike the listed equity universe, where ESG data is more readily available, it
This approach resulted from rigorous quantitative testing which applied various negative and positive exclusionary screens to the firm’s existing Absolute Return Credit fund to determine what the return profile of the fund would have been were TwentyFour to have turned it into a sustainable product.
The approach to ESG for Bowie and Twenty Four Asset Management was twofold: ESG integration across all of its strategies as well as focusing on launching a number of sustainability-focused bond funds. The difference between the two is significant, as it is only within the sustainable fund range that the firm applies a careful combination of negative and positive screening to create a product that they believe can offer a similar level of risk-adjusted returns to its non-ESG counterparts.
According to Bowie, the main difference between the group’s core sustainable funds and integration is that ESG integration “doesn't stop [the managers] buying companies that might have relatively poor ESG scores”, although when investing in riskier companies from an ESG standpoint “you need to be compensated by being paid a much higher yield for these investments”.
Integration means the group considers ESG factors as part of its relative value decision alongside traditional methods of credit analysis. Every portfolio manager has to integrate ESG factors into their decisions and it helps form assessments of relative value. From there the managers determine the yield they require from the potential investment to accept those additional ESG risks. If the company looks risky in terms of ESG factors, the yield needs to be much higher.
ESG integration versus sustainable-focused funds
This assessment helps focus engagement as well. “We do not get to vote but we can influence behaviour through our engagement. In fact we share this with our clients and publish reports about our engagement meetings on our website quarterly because we understand transparency is key to inciting change.”
The group has also written about company practices through its blog on its website in order to challenge decisions that reflect badly in terms of ESG. For example, in 2018, Aviva announced it was going to cancel its preference notes at par, with large losses for mainly retail holders.
“We saw this as an example of treating stakeholders poorly, and differently. It gave us concerns about their willingness to call subordinated debt at future call dates,” says Bowie, who at the time reached out to the finance and investor relations teams. “But we also realised we have the power of our blog; and within one week of publishing our concerns we were pleased to see Aviva had reversed their position.”
“We find it helps to get comfortable with a company that's moving in the right direction and then you can look to invest in all of their bonds and enjoy the benefit of that company becoming cleaner and greener,” Bowie explains.
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“A company that scores relatively poorly today but has a board committed to change means that its momentum score would reflect the fact the future for this business should be better,” he says.
Adding a positive screen adds returns, but also volatility. If the filter is too high, diversification becomes a problem
A minimum ESG score of 34 maximised the Sharpe Ratio
At a minimum ESG score of 80, just 28 bonds qualified
The Observatory is a proprietary bond database and relative value tool built by TwentyFour Asset Management, which helps the firm measure and track the ESG credentials of different bonds and issuers from across the global fixed income universe.
What is Observatory?
Raw score: The scoring process starts with each company being given a raw ESG score which takes into account various E, S and G risks based on around 400 ESG data points. The weighted average of Asset4 and TwentyFour’s own research is what determines the raw score. This drills down into each area of ESG, covering everything from emissions levels to human rights and treatment of staff.
Controversy & Momentum score: Each company is then assigned a controversy score, which reflects any poor behaviour that could result in future risks; and a momentum score, which shows a company’s willingness to improve and how much progress it has made in this direction. In aggregate, these three scores make up the combined ESG score for each company. The database has handy colour-coded markers (green, red and white) that denote strong, middling and poor ESG performance, and allows portfolio managers to compare scores with the median to provide context.
For any investor in this area, third party ESG data is typically not enough, and often does not match expectations. But a combined scoring approach allows the team to place greater importance on engagement with issuers, which they believe is the best way to bring about positive change as a bond investor. The importance of engagement also means it can allow the managers to override a score if they believe a bond issuer is making positive changes.
The Observatory database holds records of any engagement activity conducted with each company as well as an archive of any score changes or score overrides implemented by the portfolio management team, which must always be independently verified by another team member. This ensures transparency and accountability and is constantly updated to reflect the results of engagement and validate investment decisions.
Why is it so important?
how does Observatory score bonds?
Building an ESG Observatory
TwentyFour Asset Management’s purpose-built Observatory platform scans the global universe of bonds looking for ESG stars
How twentyfour scoreS companies for Maximum effectiveness
Source: TwentyFour
Inputs
Key metrics held on
Current spread, yield data and historic volatility information on every bond is analysed and combined
Questions the Observatory helps TwentyFour answer:
Portfolio construction thus focuses on bonds that drive return per unit of risk at the fund level
Observatory is like TwentyFour’s very own search engine for the bond markets, storing key metrics on over 26,000 securities across sovereigns, credit and high yield. ESG analysis is built right into this software alongside more familiar metrics to bond investors such as yield and maturity, which ensures ESG is a factor in every investment decision TwentyFour’s portfolio managers make.
How the Observatory system helps look for stars in the credit universe
26,000 bonds
every day, across global IG, HY and Sovereigns
• Which bonds drive volatility?
• Which bonds are not giving enough return per risk?
• Which bonds are rewarding investors for the volatility?
Outputs
ESG Database
TwentyFour Portfolio Managers
Weighted Scores E S G
Raw Score
Controversies Score
Combined Score
Team Review
Inter-quartile relative comparison with appropriate peer group available for ESG controversies, momentum, raw and combined scores
ESG combined with TwentyFour credit analysis
BUY SELL HOLD
Controversy examples
Momentum Score
Engagement
• Polluting the environment • Guilty of predatory pricing
A company’s credible plan to improve weaknesses identified in their ESG credentials
How twentyfour AM's proprietary Observatory system helps them look for stars in the credit universe
Questions the Observatory helps TwentyFour AM answer:
How twentyfour AM score companies for Maximum effectiveness
Engagement (where applicable)
ESG analysis is then combined with other Observatory variables, PM credit and technical analysis
ESG Database TwentyFour PM Adjustments (If Required)
• Polluting the environment
• Guilty of predatory pricing
The Observatory is a proprietary bond database and relative value tool built by TwentyFour Asset Management to help it navigate the ESG fixed income space. It was created when the portfolio management team realised that commercially available ESG databases covered only around 60% of TwentyFour’s bond investment universe.
The database uses external data from Asset4, a Research Financial ESG database, alongside the group’s own in-house research to gather key metrics on over 26,000 bonds from across the global sovereign, credit and high yield markets. It allows the portfolio managers to score all the bonds they invest in on a range of quantitative and qualitative ESG metrics and update these scores on a regular basis.
Controversy & momentum score: Each company is then assigned a controversy score, which reflects any poor behaviour that could result in future risks; and a momentum score, which shows a company’s willingness to improve and how much progress it has made in this direction. In aggregate, these three scores make up the combined ESG score for each company. The database has handy colour-coded markers (green, red and white) that denote strong, middling and poor ESG performance, and allows portfolio managers to compare scores with the median to provide context.
how does it score bonds?
For any investor in this area, third party ESG data is typically not enough, and often does not match expectations. But a combined scoring approach allows the team to place greater importance on engagement with issuers, which they believe is the best way to bring about positive change as a bond investor. The importance of engagement also means it can allow the managers to override a score if they believe change is afoot.
The database holds records of any engagement activity conducted with each company as well as an archive of any score changes or score overrides implemented by the portfolio management team, which must always be independently verified by another team member. This ensures transparency and accountability and is constantly updated to reflect the results of engagement and validate investment decisions.
Observatory is populated with external data from Asset4, a Research Financial ESG database, along with the group’s own in-house ESG research. It allows the portfolio managers to score all the bonds they invest in on a range of quantitative and qualitative ESG metrics and update these scores on a regular basis.
Observatory is at the core of TwentyFour’s ESG integration, but it is also the tool that powers the firm’s sustainability focused funds, as it allows portfolios to be screened positively and negatively by ESG score.
individual investors and institutions when it comes to ESG.
he definitions of what ESG really means are still blurry and there is no one-size-fits-all approach to sustainability. If anything, the growing popularity of these funds has highlighted the differences in the expectations of both
T
When it comes to fixed income, passive index strategies face a number of limitations. Chief among these is the data challenge. Due to the nature of the fixed income universe, where a large number of issuers are not publicly listed companies, data coverage is average at best, with up to 40% of the investment universe typically not covered. Naturally, this creates a problem for building an ESG fixed income index.
But even where data is available, there is no guarantee that a company with a high ESG score is truly making the world a better place. Graeme Anderson, a founding partner at TwentyFour Asset Management, says “rule-based systems can be gamed” by large corporations that have money to throw at ESG reporting, resulting in ESG data being skewed in their favour.
He gives Coca-Cola as an example, a company most of us would not consider an ESG investment. The company contributes to plastic pollution and child obesity by selling sugary drinks to children.
The other concern is that a passive ESG strategy ignores a company’s direction of travel, which TwentyFour has dubbed the “momentum score”, as the resources for this research simply aren’t there. This means that even if the companies in a passive ESG fund are as good as their ESG score suggests, there is a missed opportunity in terms of driving positive change. For many investors, this is the real goal of ESG investing.
“Some of the best-performing credits are likely to be those companies that score relatively poorly today but are committed to change,” says Chris Bowie, partner and portfolio manager at TwentyFour. The best way for fixed income investors to drive this change, he believes, is regular engagement with companies: something a passive fund, yet again, is unable to do.
But part of the problem also comes down to the nature of bond investing itself, according to Bowie. When investing in equity, the upside is “essentially unlimited”, he says, while as a credit investor, “the best thing that can happen to you is that you get your money back”. As such, bond investors “have to be very careful about who [they] loan money to because there is more downside risk than upside”.
Anderson adds that a fixed income investor is often required to quickly engage with companies in response to market events, such as a subversive buyback of a bond, which necessitates an active management team.
Finally, and perhaps most importantly for investors, TwentyFour’s research shows that applying negative exclusionary screens – the most common approach to passive ESG investing – can be detrimental to returns in credit investing, while simultaneously increasing volatility.
Equally, many of the passive ESG fixed income funds in the market invest in green or sustainable bonds, which according to Anderson is often the least preferable choice for those wanting a truly sustainable fixed income portfolio. While typically offering a low level of yield, he notes the green bond market also currently applies a rules-based ‘box-ticking’ approach which “simply doesn’t cut it in the world of ESG”.
Clearly, the reasons for choosing an active approach to ESG fixed income are numerous. Active managers can help solve the data scarcity problem, drive positive change through engagement, quickly respond to controversies and support companies on a path to improving their ESG credentials. Coupled with the promise of a similar risk-adjusted return to their traditional fixed income counterparts, active ESG bond funds can be the product of choice for investors who are serious about putting their money to good use.
To be truly sustainable, funds need to be actively managed. Here's why.
Index limitations
Driving positive change
Performance enhancement
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However, Anderson points out that in most databases, the company scores well as it knows how to profile itself. “So if you just take a rating or a profile with a passive fund, you're probably buying Coca-Cola,” he says.
This was the conclusion of quantitative testing on the firm’s Absolute Return Credit fund when TwentyFour was preparing to launch its sustainable product suite. The firm's ESG bond strategies feature a carefully calibrated mix of negative and positive screening, which requires detailed research and data. This comes back to the issue of data availability, a key stumbling block for passive investing in fixed income.
One question is being asked with increasing frequency: is it really possible to create a truly sustainable fund using a passive strategy?
reasons to go active when it comes to ESG
Click to explore each reason
The data problem
Qualitative metrics
Static approach
Forced buyers
Inconsistent scoring
Active research takes into account qualitative metrics such as controversies, which rules-based models often struggle to pick up. Even when they do, what some of these models consider material may not be a negative issue. For example, the Asset4 model considers acquisitions a ‘controversy’, something the TwentyFour portfolio management team disagrees with, since acquisitions are not inherently positive or negative and bondholders can judge each on its own merits.
Passive funds can become forced buyers when an index is rebalanced, and conversely cannot sell out of a company that is in the index. As a result, engagement that will actually drive change is difficult or impossible.
Passive investing doesn’t take into account momentum, i.e. a company’s movement in the direction of positive or negative change. Negative screening rules can work in some circumstances, but the role of sustainable investing is also to push for better ESG outcomes, for which an active approach is far better suited.
Different ESG data providers often award the same company vastly different ESG scores based on the issues they consider material. For example, Tesla typically gets a high environmental score for its work on electric vehicles but is given a low governance score and marked down for toxic material mining practices. So is it a good or bad ESG investment? That will depend heavily on the data provider, and what weighting their scoring process gives to the E versus the G.
ESG data in the fixed income space is often limited and typically covers only up to 60% of the investable universe, so index construction can be difficult and unreliable. Active managers are able to fill this data gap through rigorous in-house research.
Passive funds can become forced buyers when an index is rebalanced, and conversely cannot sell out of a company that is in the index. As a result, engagement that really drives change is difficult or impossible.
Active research takes into account qualitative metrics such as controversies, which rules-based models often struggled to pick up. Even when they do, what some of these models consider material may not be a negative issue. For example, the Asset4 model considers acquisitions a ‘controversy’ – something the TwentyFour portfolio management team disagrees with as this is typically a concern for equity investors rather than bond investors.
Different ESG data providers often award the same company vastly different ESG scores based on the issues they consider material. For example, Tesla typically gets a high environmental score for its work on electric vehicles but a low governance score and marked down for toxic material mining practices. So is it a good or bad ESG investment? That depends on the weighting a provider gives to the ‘E’ rather than the ‘G’.
Tap to explore each reason
This was the conclusion of quantitative testing on the firm’s Absolute Return Credit fund when TwentyFour was preparing to launch its sustainable product suite. Their ESG bond strategies come with a mix of negative and positive screening, which requires detailed research and data. This comes back to the issue of data availability, a key stumbling block for passive investing in fixed income.
Equally, many of the passive ESG fixed income funds in the market invest in green or sustainable bonds, which according to Anderson is often the least preferable choice for those wanting a truly sustainable fixed income portfolio. While typically offering a low level of yield, he notes the green bond market also currently applied a rules-based ‘box-ticking’ approach which “simply doesn’t cut it in the world of ESG”.
Clearly, the reasons for choosing an active approach to ESG fixed income are many. Active managers can help solve the data scarcity problem, drive positive change through engagement, quickly respond to controversies and support companies on a path to improving their ESG credentials. Coupled with the promise of a similar risk-adjusted return to their traditional fixed income counterparts, active ESG bond funds can be the product of choice for investors who are serious about putting their money to good use.
Chris Bowie, partner and portfolio manager at the firm, strongly believes “the best-performing credit is likely to be those companies that score relatively poorly today but are committed to change”. The best way to drive this change for a fixed income investor, he believes, is regular engagement with companies: something a passive fund, yet again, is unable to do.
But part of the problem also comes down to the nature of bond investing itself, Bowie explains. When investing in equity, the upside is “essentially unlimited”, while “as a credit investor, the best thing that can happen to you is that you get your money back”, he says. As such, bond investors “have to be very careful about who [they] loan money to because there is more downside risk than upside”.
When it comes to fixed income, index strategies face a number of limitations. Chief among these is the data challenge. Due to the nature of the fixed income universe, where a large number of issuers are not publicly listed companies, data coverage is average at best, with up to 40% of the investment universe typically not covered. Naturally, this creates a problem for building an ESG fixed income index.
But even where data is available, there is no guarantee that a company with a high ESG score is truly making the world a better place. Graeme Anderson, a founding partner at TwentyFour Asset Management, explains that “rule-based systems can be gamed” by large corporations that have money to throw at ESG reporting, resulting in ESG data being skewed in their favour.
growing popularity of these funds has highlighted the differences in the expectations of both individual investors and institutions when it comes to ESG.
he definitions of what ESG really means are still blurry and there is no one-size-fits-all approach to sustainability. If anything, the
