Where is fixed income in its ESG journey?

Executive summary:

Active ownership has emerged as an essential engagement tool, extending beyond equities to encompass fixed income markets.
Despite increasing availability, challenges persist in Environmental, social and governance (ESG) data coverage across various segments. While corporate credit markets have led to sustainability integration, lower-rated and privately held companies often exhibit limited ESG data coverage.
Third-party data providers have continued to expand their reporting capabilities and coverage in measuring greenhouse gas (GHG) emissions.
Sustainable outcome-focused strategies have expanded beyond green bonds to encompass various segments, including high yield bonds, emerging market debt, and multi-asset credit strategies.

ESG integration is a trend financial markets are familiar with, but that doesn’t mean all asset classes are at the same levels of progress. ESG means different things to different people, and its integration into equity investment does not represent the same journey experienced in fixed income.

Fixed income markets are witnessing a rapid evolution in ESG integration and product offerings to align with the dynamic sustainability preferences of clients. At Russell Investments, we have monitored practitioners and have identified the pivotal trends shaping ESG integration in the asset class.

Engagement

Over recent years, we have observed rapid shifts with practitioners embracing engagement practices. Active ownership has emerged as an essential engagement tool, extending beyond equities to encompass fixed income markets.

Bond investors, as significant capital providers, are increasingly engaging with issuers on ESG-related agendas to assess risk and return opportunities. While bondholders may lack direct voting rights, their influence in shaping corporate behaviour through proactive engagement is substantial. Successful engagement initiatives have led to increased transparency, labelled bond issuance, and the adoption of sustainability initiatives.

However, since fixed income investing is primarily focused on diversifying and moderating the risks associated with equity investing, it is unsurprising that ESG considerations have historically mostly been considered a risk mitigation exercise rather than the expression of sustainability criteria.

Data coverage

Despite increasing availability, challenges persist in ESG data coverage across various segments of the fixed income market. While corporate credit markets have led to sustainability integration, lower-rated and privately held companies often exhibit limited ESG data transparency.

Part of the challenge to mapping ESG-related information in fixed income markets is that any entity can issue debt at a holding, operational, and subsidiary level, with different seniorities, whereas stock is often issued at an ultimate parent level. Therefore, ESG data coverage gets trickier in the fixed income space since each entity level can have different data coverage and business models. While the overall market coverage might have increased year on year, the underlying security level analysis and data quality still require scrutiny.

Regulation

Regulators around the globe are playing a vital role in how the investment industry is incorporating ESG practices. European regulators have introduced the Sustainable Finance Disclosure Regulation (SFDR) to increase the transparency and accountability of investments claiming to have ESG or sustainability objectives.

The European regulator has also established a classification framework - EU Taxonomy - to determine whether economic activity is an Environmentally Sustainable Investment. There are signs that other regions, like the U.S., are following a similar path towards developing taxonomies and standards.

However, reportable data gaps still exist in the fixed income market around ESG considerations, with bond investors trying to comply with regulations despite the data not being readily available for certain fixed income segments.

Reporting/climate risk measures

Regulatory mandates and investor demand are accelerating the adoption of ESG reporting and climate risk measures in portfolios. Third-party data providers have continued to expand their reporting capabilities and coverage in measuring GHG emissions, with frameworks such as the TCFD providing valuable guidance on measuring and reporting climate risks.

The sustainability reporting criteria continues to expand, with examples of additional categories including the United Nations Sustainable Development Goals (SDGs). While the SDGs provide a common framework for defining the positive impacts, they leave much subjectivity in mapping underlying investments to certain SDGs, allowing different methodologies to measure investment impacts.

For example, one methodology might look for revenue or activities to map to SDGs, while another will estimate a positive minus negative impact by converting all activities into asset values. Therefore, investors should be mindful of different methodologies and how they can lead to different impact outcomes.

Product availability

The demand for sustainable investment products has led to a proliferation of offerings within the fixed income market. Sustainable outcome-focused strategies have expanded beyond green bonds to encompass various segments, including high yield bonds, emerging market debt, and multi-asset credit strategies.

Investors are prioritising climate-focused outcomes and alignment with UN SDGs, which is driving the development of impact-focused strategies. However, challenges persist in areas such as biodiversity-focused investing, where the market is still nascent. This might be due to biodiversity being classified as thematic investing, making it relatively easier for equity investors to construct a portfolio with a handful of names but harder for fixed income portfolios that prefer broader diversification to limit idiosyncratic risk.

Despite these challenges, the expansion of sustainable product offerings underscores the growing momentum towards integrating ESG considerations into fixed income investment strategies. There is a clear trajectory towards greater transparency, accountability, and alignment with sustainability goals. As the industry evolves, leading practitioners will continue to innovate and define methodologies that effectively capture the impact of ESG considerations on investment outcomes.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.