BUT TWO THINGS HAVE CHANGED
More recently, we have incorporated sophisticated tools for measuring and ranking ESG performance at the issuer level. By formally embedding these tools into our research efforts, we have enhanced our ability to assess the opportunities and threats that ESG factors may pose to a company’s overall credit quality.
The second change may turn out to be even more consequential. Simply put, the market is paying more attention to ESG. Historically, outside of one-time headline-grabbing events such as oil spills or corporate scandals, we have not observed a strong correlation between a company’s ESG profile and the prices at which its bonds trade. We expect that to change, in no small part because investors now place added importance on ESG factors—especially the potential impact of climate change. As investor demand adjusts to this new norm, so will the bond market. Over time, we believe issuers with weaker ESG scores will be forced to pay a premium to sell their bonds.
The Global Fixed Income team manages a range of mandates, from corporate-only to multisector fixed income opportunity sets, and we use corporate bonds across all portfolios where guidelines allow. Our ESG philosophy tenets are an important aspect of all our investment decisions, but this paper will focus on corporates: how we think about ESG in the corporate bond market and how this philosophy impacts investment decisions at the issuer level as we build global fixed income portfolios. Our process continues to evolve, but our goal is always the same: to produce the best risk-adjusted returns for our investors.
OUR ESG PHILOSOPHY
We have already laid out two elements of our ESG philosophy: as fiduciaries, we have a duty to consider all financial and non-financial risks, including material ESG factors, when assessing potential investments; and our belief that over time, ESG issues—particularly climate change—will be reflected in valuations and impact the financial performance of our clients’ assets.
We also believe ESG is a two-way street. Many investors focus exclusively on ESG risks: what can go wrong that might depress the value of a given security. We are interested in both risks and opportunities. We believe that by identifying strong or improving ESG stories, we can tap upside potential that may not be currently priced into the market while also encouraging companies along a positive path.
Our approach to ESG isn’t about exclusion. Some investors evaluate ESG performance to eliminate companies and whole industries from their portfolios. We compare a company’s ESG standing to the overall investment universe and to the other players within its industry. Even in industries like energy or utilities, which may face more ESG challenges than other parts of the market, there can be opportunities to find best-in-class issuers or companies whose ESG performance is on the upswing. Incorporating that assessment into our relative value decision making is the ultimate goal.
We are long-term investors. In all our work, we are focused on identifying the forces that will influence the value of a security over a period of years. When we identify potential ESG problems in the companies we follow, we address them with management. Ultimately, we prefer engagement to divestment. We want to see that companies take these matters seriously and are working to make the situation better. If both are true, we can be patient investors. If not, we may view the risks as too high and sell.
ESG INTEGRATION AND ENGAGEMENT
Our ESG integration and engagement process is multifaceted. We assemble quantitative and qualitative inputs to build a full picture of issuers, industries and the overall investment universe. To do this, we work closely with the Loomis Sayles Credit Research group on proprietary ESG research and analytics. We also integrate third-party ESG data. Third-party data provide a useful perspective, but our in-house work tends to be more forward-looking than off-the-shelf resources. The proprietary processes and tools described on the following page are an essential part of the Global Fixed Income investment process:
The Global Fixed Income team works closely with Credit Research to understand the methodology behind their materiality maps and the Loomis Sayles ESG scores so we can appropriately incorporate them into our portfolio decision-making. Loomis Sayles’ ESG scores take an industry perspective, which enables the analysts to highlight the strongest and weakest players in that industry regardless of the particular ESG issues it faces. This approach lets us focus on how issuers are handling the key ESG issues for their industry, and on identifying improving and industry-leading portfolio candidates. We believe that zeroing in on ESG issues that are material to financial performance allows us to remove short-term headline noise and concentrate on what we believe will truly drive credit fundamentals and valuations over time. It also informs our decisions about top-down industry positioning. Some industries face long-term headwinds, such as stranded assets within the energy sector. We must account for those risks while balancing them with shorter-term value opportunities.
ESG IN PORTFOLIO CONSTRUCTION
In building our portfolios, we bring together all of these elements, paying special attention to the companies with scores of 1 and 3, since they typically represent the greatest potential risks and opportunities. In the end, for ESG and all other factors, we ask one fundamental question: Are we being compensated appropriately for the risks we are assuming? To answer that we look at the spread premium or discount we are being offered. That discount or premium may vary over time depending on how companies adjust to deal with material issues, and we rely on our analysis and engagement to continuously assess it. We also use another of our proprietary tools, known as Unified Relative Value, to help us ensure we are aware of the risks and opportunities in all the outliers—those where the spreads are unusually wide or narrow. This tool, shown below, visually flags outliers, highlights internal ESG scores and is a centerpiece of our ongoing relative value conversations with Credit Research analysts and our trading desk.
In partnership with Credit Research, we actively look for issuers whose valuations do not yet reflect their strong ESG stories. Companies can experience a virtuous cycle when their ESG scores are rerated and underlying credit quality actually improves as the ESG story plays out. We believe our Credit Research analysts’ forward-looking approach to ESG and engagement can help identify these opportunities early. On the flipside, before we make an initial investment in a company that has a material ESG concern, we ask two questions: 1) Can we engage with management to help drive improvement? 2) Are we being sufficiently compensated for the risk? If the answer to the first question is no, the risk-reward is not in our favor. When we hold issuers with a weak ESG score (LS ESG score of 3), we need to see improvement over time even if we feel we are being adequately compensated for the risk in the short-term. Absent a path to improvement, we will typically sell because we view the long-term risk as unacceptably high.
OUR VIEW ON CLIMATE CHANGE
As we mentioned earlier, we firmly believe ESG factors will have a growing impact on the financial performance of our clients’ assets. That is especially true for climate change, the most high-profile environmental issue. Rising seas, more powerful storms and intensifying wildfires have heightened awareness of changes in climate, and we expect that to continue. In our view, reducing the carbon footprint in our portfolios will yield long-term benefits.
As investors striving to generate alpha, we are always looking for ways to understand and incorporate climate change data. At the firm level, Loomis Sayles has contracted with a climate change consultant to deepen our knowledge on this subject. We continue to evaluate climate scenario tools so we can measure the impact rising temperatures are likely to have on our portfolios. Global standards continue to develop and corporate disclosures continue to improve; we want to be at the forefront of investment firms using this information to make decisions.
ESG investing is evolving, and we are evolving with it. As new tools and better information become available, we are exploring how we might use them to enhance our investment process. It is our fiduciary duty to understand the risks and opportunities our portfolio companies face today and may face in the future. As we said at the outset, we are interested in everything that can influence corporate performance. Integrating and engaging on ESG issues across our portfolios is part of our commitment to providing superior investment returns for our clients.
This paper is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein, reflect the subjective judgments and assumptions of the authors only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual, or expected future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis cannot guarantee its accuracy. This information is subject to change at any time without notice.
Past performance is no guarantee of, and not necessarily indicative of, future results.
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