No voting rights? Engagement still matters in fixed income
For equity investors, active ownership is the use of shareholder rights to advocate for good corporate governance and to improve the long-term value of a company. Corporate engagement is a direct dialogue between an investor and the company in which the asset owner or market practitioners are invested. Active ownership often utilises engagement to seek its desirable outcomes, so the term engagement has been a mainstream investment concept in equity investing.
That said, we have observed a trend in which many fixed income market practitioners have started to utilise the engagement terminology as a part of their environmental, social and governance (ESG) integration efforts. There is a growing view that engagement can be an important feedback loop to allow asset managers to obtain more comprehensive views of the underlying companies. So, we’d like to take a moment to discuss the engagement implications in fixed income investing.
Level of engagement
While bondholders do not have voting rights per se, as capital providers to corporations, they do have a direct line of access and communication to management. For instance, the global bond market consists of over $60 trillion in market capitalisation. In our 2019 Annual ESG Manager Survey, we asked market practitioners to state how often they engage with underlying companies related to ESG issues. The results from the survey showed that 89% of market practitioners with both equity and bond offerings and 71% of market practitioners with bond-only offerings claim they often or always discuss ESG topics when they interface with companies they are invested in.
The heightened market interest in ESG considerations has led many underlying companies to be more amenable to proactively discussing ESG related topics. That said, the explicit limitation exists for bondholders who are without proxy voting. We believe that when market practitioners simply raise an ESG topic to the underlying companies, it is not necessarily sufficient to call it engagement. The reality is that bondholders can only express ESG topics in the underwriting process in an explicit manner, by incorporating some ESG provisions in the credit agreement at pre-new issuance, which occurs infrequently.
What we have observed is that the fixed income market practitioners, with equity offerings, leverage their equity counterparts to increase influence when engaging with the underlying companies. And some bond managers who have limited, or no equity offering, try to partner with other bond managers to increase influence as collaborate engagement. For example, Climate Action 100+, an investor-led climate engagement coalition launched in 2017, helps facilitate such bond managers to collaborate the engagement activities with other investors.
Establishing best practice
When it comes to the engagement practice, we have observed that an increasing number of fixed income managers have started to disclose an amount of engagement activities they have conducted. While the quantity of engagement activities might indicate the resourcing aspect of asset managers, we believe the quality of such activities is more important. A number of asset managers have a framework in place to prioritise engagement activities for the efficient use of their resource. Engagement activities might be proactive or reactive. When asset managers engage with bond issuers in reaction to certain events, the dialogue with those companies can provide some information about the direction of the company, but much of the risk associated with a certain event might be already priced in. For proactive engagement activities, several considerations can play into the prioritisation. Many bond managers prioritise engagement activities based on a size of their investment exposure to maximise their influence. Additionally, many target bond issuers who are more interested in sustainability and receptive to engagement dialogues. Finally, investors also consider materiality of industry-specific and company-specific risks for the prioritisation.
Engagement activities should possess specific objectives in attempts to achieve certain outcomes. Some bond managers establish the objectives once they identify companies. Others select certain objectives or themes first, then identify which companies to engage with, based on specific industries and/or poor ESG profile of the companies. Some bond managers select certain themes, such as climate risk, board-related issues, cyber security and/or most relevant UN Sustainable Development Goals (SDGs). The effective engagement activities involve productive dialogue and collaborative relationship with underlying companies.
The engagement activities should be documented and monitored, in order to gauge the efficiency of such efforts. A vast number of bond managers have started to track their engagement activities from initial stage with the progress available to the internal portfolio managers and analysts. While such activities are in part designed to seek specific outcomes, not generating specific outcomes is often still useful, since the dialogues themselves provide insight into the company’s directions.
Who does what
At Russell Investments, we have observed that many bond managers have an ESG or responsible investing team, which initiates engagement activities that is distinct from their investment team. A number of firms are ramping up dedicated efforts in ESG initiatives - adding resources to the ESG team, especially those firms with a larger asset base. And we have observed that investment practitioners with a large asset base tend to have a separate ESG team, whereas smaller asset-based firms leverage an existing investment team for conducting ESG-related investment analysis. Engagement activities often still reside with the existing credit team which has already established a relationship with underlying companies. For the larger firms with separate ESG teams, we look for evidence that the separate team is influential in engagement activities and security selection, while assuring that the importance of investment value is still the top consideration. For smaller firms adopting engagement practice, the challenge is to demonstrate that the resource is efficiently seeking desired engagement outcomes.
The role of segmentation
There are different considerations in the engagement practice, depending on market segments. The ability for bondholders to influence bond issuers also depends on how often bond issuers issue debts for their capital needs: Repeated bond issuers are more incentivised to listen to bondholders.
Investment-grade corporate bond issuers are, by definition, companies with higher credit ratings with healthier financial conditions. Such companies are often larger in size and listed on the stock market. Investment-grade companies often have dedicated personnel in investor relations which are accustomed to address investor needs. Therefore, the transparency of the investment-grade bond issuers tends to be greater than that of the below-investment-grade bond issuers. As such, engagement activities seem to be more established among investment-grade bond managers.
But we have started to see gradual expansion of engagement efforts among below-investment-grade bond managers, such as high yield managers. Here, bond managers focus on the existing relationship to engage, henceforth the credit analyst team often drives such engagement activities. Depending on the market conditions, one can say high-yield issuers potentially have a greater incentive to listen to potential investors’ needs, as their ability to access capital market is less than those of investment-grade companies. There are more private companies in the high-yield market than in the investment-grade corporate market. Private companies often lack transparency, such as transparency into the composition of board membership. While high-yield managers were already communicating with underlying companies’ managements and their stakeholders, the engagement activities are shifting dialogues to ask broader questions. Many high-yield managers focus on increasing transparency and influencing corporate behaviours in efforts to improve the long-term enterprise value of the company.
Engagement activities with sovereign issuers can be a very challenging concept, as change is slower at the country level than at the company level. In the meantime, an election cycle can cause government policies to change. But we have seen emerging market debt managers trying to engage with bond issuers to seek sustainable outcomes. Many emerging-market countries seek global capital markets to finance their capital needs. Therefore, the incentive is there to engage with corporations with investors bases. And collaborative engagement – where a group of institutional investors comes together to engage with entities – appears to be a popular engagement practice with sovereign-debt investors.
The bottom line
Bondholder engagement has become a crucial part of responsible investment approach and process. A growing number of bond investors have the view that engagement activities can provide greater insights of the underlying companies or entities, improve transparency and influence business practices. As the importance of active ownership continues to increase, so will the consensus among investors to incorporate active management across all asset classes. Asset managers have a pivotal and vital role to play in the quality of active management taking place - ensuring value-adding conversations are happening between investment practitioners and the companies in which they’re invested.
At Russell Investments, we continue to observe and monitor the evolution of how the asset management community are embracing their responsible investment practice. As significant capital providers, we believe fixed income investors can play an essential role in supporting the overall sustainable goals and addressing investment risks. As we move forward, standout approaches will be to demonstrate clear methodologies, articulate a best practice and demonstrate effective engagement practices.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.