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FEATURE STORY April 19, 2018

Incorporating Environment, Social and Governance (ESG) Factors Into Fixed Income Investments

The World Bank Group and Japan’s Government Pension Investment Fund (GPIF) have formalized a partnership that aims to expand markets for sustainable investing.  Under the partnership, the World Bank Group and GPIF will collaborate on initiatives that promote strategies for including environmental, social and governance criteria in investment decisions across different asset classes. Ultimately, the aim is to direct more capital towards sustainable investments.

To address these gaps, as a first step the World Bank Group and GPIF will develop a joint research program that will explore practical solutions for integrating sustainability considerations into fixed income portfolios. Potential areas of research include benchmarks, guidelines, rating methodologies, disclosure frameworks, reporting templates and risk correlation for incorporating environmental, social, and governance considerations into fixed income portfolios, including for sovereigns and sustainable bond markets.

This research report provides an overview on sustainable investing in fixed income that is developing fast these days. It discusses the core areas of:

  1. The specific nature and issues of ESG investing in this asset class
  2. The rationale for ESG analysis in fixed income – including research findings
  3. ESG investment tools and ways of implementing ESG strategies in fixed income
  4. On-going challenges to greater integration of ESG into mainstream investing
  5. Suggestions for how to catalyze the further adoption of ESG approaches

The main findings of the report include that a growing body of research shows that Environmental, Social and Governance (ESG) factors are material credit risk for fixed income investors. The evidence suggests that incorporating ESG into fixed income investing should be part of the overall credit risk analysis and should contribute to more stable financial returns. It also dispels the myth that incorporating ESG means having to sacrifice financial returns. ESG investing is increasingly becoming part of the mainstream investment process for fixed income investors, as opposed to a specialist, segregated activity, often confined to green bonds.

Though fixed income has its own challenges with integrating ESG issues, it is catching up fast with the equity space (particularly corporate and supranational bonds but less - so far - sovereign issuers, asset-backed or private debt). Leading investors are going further and viewing ESG not just as an aspect of risk and return, but merging ESG and ‘impact’ investing. This includes measuring the impact of their portfolios on targeted environmental and social outcomes, and beyond, such as mapping impact using the Sustainable Development Goals (SDGs).

Yet, many investors find implementing ESG in practice a challenge, which can be exacerbated when it comes to their fixed income portfolios. There are still no standard definitions of ESG – with diverse views particularly in the ‘social’ area. Data – though improving and coming from increasingly diverse sources – is still wanting particularly in emerging markets. In fixed income, there are additional issues such as how to pursue engagement with issuers (particularly sovereigns), the role ESG plays in credit ratings, the lack of choice of indices compared to the equity space, as well as a dearth of specific ESG-focused products. There are also challenges in the green bond markets with demand outstripping supply. Conceptual work on ESG and fixed income also needs to go beyond credit risk (such as the relationship of ESG issues with liquidity and other market risks).

ESG investing is developing from a purely process-driven to a more outcome-driven activity. Going forward, first, the initiatives to improve the breadth and depth of ESG data should continue to be supported. More rigorous research on the relationship between  ESG factors and financial risks and returns, particularly in fixed income, is also required. Second, standards, principles and metrics for applying ESG and impact investing can be refined to allow investors to customize their approach from a robust basis. Finally, more innovative, scalable products to accommodate the growing demand for fixed income sustainable investments could be developed.