Unlocking markets: exploring the ESG landscape in fixed income investing

Unlocking markets: exploring the ESG landscape in fixed income investing

By My-Linh Ngo, Senior Director and Impact-Aligned Strategist, Tom Moulds, Senior Portfolio Manager, and Mike Reed, Head of Global Financial Institutions

Mike Reed:  00:04
Hello, and welcome back to Unlocking Markets, the RBC BlueBay podcast where we bring you experts from across our firm, providing opinions on markets, global policy, sustainability, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, Head of Global Financial Institutions. Today, I'm joined by My-Linh Ngo and Tom Moulds. My-Linh is a Senior Director and Impact-Aligned Strategist at RBC BlueBay, with nearly 25 years' experience in ESG and responsible investing, while Tom is a Senior Portfolio Manager within our global Investment Grade team.

Tom is the lead manager for many of our ESG-orientated strategies, including our Article 9 Impact-Aligned Bond Fund, where he works closely with My-Linh. Today, we'll be diving into the world of ESG, a topic that has increasingly been at the forefront of both investors' and regulators' minds. We will focus on how we think about ESG at RBC BlueBay, and how it can be incorporated into fixed income products. Welcome My-Linh and Tom. Thank you both for joining me; a really exciting topic for today's podcast and lots for us to discuss.

Tom Moulds:  01:15
Hi, Mike.

My-Linh Ngo:  01:16
Hi, Mike. Thanks for having us on here.

Mike Reed:  01:18
My-Linh, if I can start with you. Three years ago, ESG became a huge thematic in the European investment world, with the introduction of the Sustainable Financial Disclosure Regulation, SFDR. Although intended as a disclosure regime, in practice, SFDR has ended up being a type of product labeling, and we've seen many managers either rush to reclassify their existing products as either Article 8 or even 9, or launch new ones in the belief that this would make them more attractive to investors.

However, after a couple of years of poor relative performance from quite a few ESG equity funds, we've seen some outflows across the industry. Additionally, we observed some high profile asset managers downgrading the classification of their funds in the wake of increasing concerns about greenwashing, and also a rising tide of anti-ESG sentiment in parts of the United States. I guess, is the demand and shift at ESG-focused funds now over, or do you think it will continue? If so, why?

My-Ling Ngo:  02:17
Gosh, what a good question there, Mike. I guess the short answer is at a high level, maybe not surprising, I'd say that it's not over, and I think it will continue to remain relevant for many reasons, why we should be incorporating ESG into investment practice, and I'll expand on those in a minute. Maybe in order to support those cases, I'd like to just start off briefly by explaining what ESG or responsible investing is, because I think that's important to giving context to what I'll say.

At its most basic, I'd really encourage your listeners to think of this as a form of investing which seeks to incorporate non-financial traditional factors, environmental, social, governance ones within the investment process. Critically, the motivation and objective for doing so varies. It could be, for instance, to enhance risk returns or to apply a person's personal principles and values, or to bring about real world change. Also, because of this, the approaches that you might apply might vary. For example, you might apply exclusionary screening, or you might be looking to invoke shareholder activism, or you really might be looking to invest in companies providing solutions to environmental or social problems.

This sort of description is really important because one of the first reasons I think it will exist is that it's not just about negative screening. I think that's what a lot of the market thinks about. It's a lot about exclusions, but I think in this definition I've just given you, it shows it really is about a spectrum of different approaches. For that reason, because of those different motivations, it will continue to exist in some form.

Secondly, I want to destroy another myth in terms of giving a reason why it will continue, and that is because it's not about sacrificing returns necessarily. This has come about because, again, linked to the first point, people think it's about negative screenings, you're excluding huge parts of the market, and you might be giving up returns. That simply is not the case because, as I explained to you, it can be used as an enhanced risk management tool.

The reason for this is that people are increasingly recognising that when you're making investments in companies, taking into account these non-financial factors can actually give you a more holistic view about a company, and so you can actually make a more informed choice. The reasons why ESG issues are becoming increasingly relevant is because they're so important now in the market that they represent systemic risks. They represent really material risks to financial markets and society at large.

That's why there is a business case for those. Because of these issues, I don't think it'll go away. I guess my last reason I wanted to give, and again, to destroy another myth, is that it's not a fad. The reason for that is linked to my other two reasons I've given you, in that it represents different approaches. There is a strong business case underlying all of this. I think the fact that the regulators, the policymakers and public at large are talking about this issue is actually a reflection of the maturity and the increasing mainstream-ness of considering ESG into the investment process. I think it's a really healthy stage where we are at. It's messy middle at the moment, but I don't think it'll go away.

Mike Reed:  05:15
That's a really great way to start the podcast. Thanks very much for that. It's given us a lot of background on where we're at. I think you're right to dispel some of the myths. It's really useful. Moving on, it's clear regulation is an increasing theme within the ESG space, and we've witnessed quite a number of different regimes being introduced across Europe, in particular, and some in the UK as well. Against this backdrop, can you share with us how this is impacting the ability of an asset manager to develop products that are suitable for a broad range of investors?

My-Linh Ngo:  05:47
Yes, gosh, Mike, you're correct. There are many challenges at the moment in the market for managers such as ourselves, in terms of when it comes to ESG regulation. Maybe before I expand on those, I think it's probably helpful to make it clear that at a high level, we are supportive of the underlying goals of regulations, in terms of their seeking to ensure efficient financial markets by making sure that it's addressing appropriate systemic risks.

We support the idea of having a level playing field, in terms of setting base level requirements for all managers to operate. Also, thirdly, we recognise the importance of protecting investors and enabling them to make choice, by ensuring there's appropriate transparency and accountability from managers, in terms of the financial products and what their ESG products are claiming to do.

However, that doesn't take away from the fact that in terms of the execution of the goal, sometimes the regulation can be quite clunky, and it may have unintended consequences. Because if you think about it, regulation can be quite a blunt instrument. Ultimately, I think we have to recognise as well, particularly in the ESG field, is that policy and regulation is very much shaped by culture and politics in those markets. You're seeing a lot of fragmentation in terms of ESG policy and regulations across markets, because they are shaped by what's actually domestically happening, in terms of how things are being addressed.

Whilst we hope for a lot of harmonisation and standardisation, and we try to make sure that that happens, and I know the regulators try to do that, it doesn't always happen. Obviously, the EU with the SFDR regulation, which you mentioned earlier, is an attempt to create a regime European wide, but then what you've seen, in effect, is individual countries have actually decided to also introduce their own domestic ESG requirements. Then within the market, more generally, you're seeing the emergence of voluntary ESG labels and standards. So, what you've got is a real hodgepodge of different approaches.

That means there's a lot of fragmentation, even within Europe and outside. I know you mentioned the US as well, where you're witnessing a lot of politicalisation and weaponisation of ESG. I think for us, it's really about understanding how do we navigate, as you said, but I'd also make another point that it's not just about market fragmentation, it's about client fragmentation. That's not new or unique to ESG, but it takes on a new complexity. For managers, I think what we're increasingly realising is that you can't be all things ESG to all people. You've really got to be focused and identify where is the space you want to play and make sure you do that really well.

If you do do it very well, I'd like to turn the question maybe from just challenges to opportunities, because I really do think it's a double-edged sword, and it's two sides of the coin. If you can do this really well, identify which space within ESG you want to sit, make sure that you appropriately resource it, address it in a very credible, thoughtful, robust way, then I think there are huge opportunities in terms of the asset gathering. I think for all of those sorts of reasons, it is a lot of challenges at the moment in terms of navigating, but it represents opportunities as well.

Mike Reed:  08:47
Challenges but opportunities at the same time, that's great. Now, let's shift focus back to the issues and topics which ESG or responsible investing relate to, i.e. environmental, social and governance. Although there are three parts to ESG, it feels like most of the emphasis today has been on environmental or green factors, with much less focus on the other two elements. Would you say that's a fair assessment? Have you noticed any increase in demands for social and governance factors from investors recently?

My-Linh Ngo:  09:16
I can certainly see where you might have gotten that impression, Mike. In some ways, it's actually quite predictable, given the characteristics of environmental issues. For that reason and other reasons, it's valid that it's got a lot of attention. I'd also say that S and G hasn't been neglected. We've certainly seen more products directed in that area, particularly on the S. They just haven't got as much airtime, as you said. For example, maybe going back to why E seems to have been very popular, and you take the issue of climate change. It's certainly one, as I mentioned earlier, it represents systemic risks to markets and society.

It's one that, rightly so, has gotten a lot of airplay. Also, if you think about characteristics of a lot of environmental issues, there's a lot of science in terms of clear cause and effect, as it were, it's easier to quantify, that makes it easier to manage. For those sorts of characteristics, it does make it an area that people feel a bit more comfortable talking about. We've seen beyond climate change, there's increasing attention turned to nature and biodiversity as another key issue that's coming up on the agenda as well, on that side.

Returning to the other parts of E, S and G, is that I definitely say S hasn't been neglected. What's happened is, or what's the challenge with it, is that it's very intangible. It can be quite subjective as well. It's very difficult to manage, as well, and measure in terms of identifying cause and effect. I think the dynamics in terms of the timescale from which it can happen is very difficult as well.

For all of those reasons, it can be a bit more difficult to talk about or to identify what's happening. Certainly, we have seen interest in this area, if you think about it, people and companies, the success of companies is dependent on people, its employees, its customers, its suppliers, the local communities. Understanding the quality and nature of those relationships is really important. I'd say in the last few years, we've seen an increase in financial products targeting diversity and inclusion or women-led businesses. They're certainly products that are getting increased traction.

Then to take the G, I'd definitely say the governance has always been material. I guess it's always been inherent in any sort of ESG product because it provides the foundations for how companies operate and address S and E issues on that side. Corporate governance and voting have always been a key part of it on that side. Hopefully, that gives you a sense that yes, S and G haven't been neglected, it just hasn't been so high profile. I guess what I'd like to leave you with, ultimately, is to encourage our listeners to not just think about the E, S and G as discrete pillars, but actually to think of them as interconnected dimensions that interact with each other.

Maybe to give you a couple of examples, if you look at climate change, it's not just about temperature rises, physical impact, it's actually the social impact of climate change as well. You need to address those to make sure that the future economies, there are people, skilled workforce to operate and work in those industries. You need to make sure that nature and climate change are addressing community issues as well. I think I'd really like to leave you with that, that there's no neglect necessarily, but the inherent characteristics of each of those makes them easier to talk about, or address and manage. Ultimately, they're all interconnected. If we're to address sustainability, we need to address the E, S and G.

Mike Reed:  12:36
That's great. It's interesting to hear how they are very much inter-linked. I would totally agree with you from the governance side that as part of good investing, working with a company that has good governance is paramount to good returns, or alternatively, poor governance is a good way to see your money disappear, as we've seen many times in the past. Thanks very much for that. It's really interesting to hear your views on a subject many investors find is often very complicated by language and terminology.

Now, Tom, I'd like to turn to you. I'd love to hear your thoughts as someone who manages an SFDR Article 9 bond strategy. Although you're a fixed income manager, you will have observed in the equity world that many ESG-themed funds have, over the last couple of years, demonstrated significant underperformance versus the broader market. In part, this is due to their underweight to energy and defense stocks, which have performed so well since the Russian invasion of Ukraine. Has there been a similar behavior within ESG-focused bond portfolios?

Tom Moulds:  13:32
Yes, it's been a really interesting couple of years for financial markets in general. Clearly, we've seen huge shifts in terms of where interest rates are and where financial markets have been trading. The thing that you point out has been quite stark, the underperformance of sustainably-focused equity funds, some of the differences to more traditional funds have been huge, in part to the things you point out. I think the other drivers have been these seven magnificent stocks, the likes of Amazon and Nvidia have also really forged the way and been, particularly last year, the best returners in the market.

A lot of the sustainably-focused strategies haven't owned these stocks, and it's created quite a big divergence. Now, within bond markets, you've seen a divergence as well in returns. I would say it hasn't been as stark as you've seen in equity markets, but a lot of those themes have played out as well. Particularly in 2023, you saw very strong performance from some of the large bond issuers that have big curves in bond markets.

These things were the things that people were after. In a period where a lot of people were returning to fixed income, they were almost the first things that they were buying. Therefore, they were the best performing parts of the market. A lot of the sustainably-focused funds didn't own a lot of these very large bond issuers. The other impact was, it was a bit of a double whammy for the market, actually, because you saw an underperformance from some of the more sustainably-focused type issuers.

Renewable energy is probably the best example, where you saw a lot of structural challenges, particularly for wind power where supply chain issues made the cost of building new wind projects very expensive, so a lot of wind projects got shelved. This caused quite a big underperformance of issuers in every part of this value chain. Again, you saw this quite big divergence in terms of how sustainable issuers were performing versus issuers that were more generic or general.

Now, what I would say, though, while you've seen this difference in the last year or so, actually if you go back over a longer period of time, it's definitely not the case. As My-Linh was pointing out, I think you can really look at investing sustainably as not being concessionary. History does tell you that, "Yes, you've had a couple of years where you've seen a bit of divergence. Actually, over the long term, you don't have a big divergence between these two types of strategies." We strongly believe that the shifting capital towards more sustainably-focused funds is actually something that will help drive returns going forward.

Mike Reed:  16:19
Great to hear. It's interesting to hear that there is this divergence in different sectors within bond markets, as well as in equity markets. I think it highlights, again, as this has to be research-led and this works with being an active manager. ESG-focused equity funds have been around for many years now, where as shareholders, the fund managers attempt to influence the behaviour of the companies, they invest in by using their voting rights and shareholder meetings. You're a bondholder and don't get a vote. How can you use your influence? How do you do this, in particular, for impact strategies in a bond portfolio?

Tom Moulds:  16:55
Yes, and I really think this is one of those things which is quite a big misconception. When you talk to people about being impactful in public bond markets, people think, well, you can't be that impactful. Bondholders don't get a vote, as you say. They don't have an equity stake in the company. I think what sometimes you forget is that companies that issue bonds in public bond markets are incredibly reliant on the bond markets as part of their capital structure.

They've built this part of their debt stack into the capital structure, and therefore, they're quite reliant on it going forward. Also, it means when you have bonds as part of your capital structure, you do constantly need to refinance them. You're constantly needing to come back to the market, which again, is something which is a bit different or can be a bit different to equities. We engage with bond issuers very regularly, because they very regularly need to come to the market.

What we've actually found is, particularly on the engagement side, it's incredible how influential you can be. When you're talking to a bond issuer, and maybe you explain to them that you're not very happy about part of what they're doing, and you feel that it's not very sustainable, and therefore it might be a reason why we would choose not to invest in them, that's really been raising alarm bells with issuers. Clearly, everybody is thinking more about sustainability now, and issuers don't want to be perceived as not being sustainable. When we engage in this fashion, it's really interesting to see how impactful we can be in changing the way they behave.

I think as simple as that, engagement is actually a very impactful part of the process. The other aspect where you can be very impactful is in the primary market. Clearly, when bonds are coming to the market, when we're talking to issuers, we're talking to syndicated banks, explaining what we want to see from new issues and how they are structured, clearly is a place where we can be very impactful as well.

Our decision whether to buy the bonds and in what size, obviously also has an impact on the market. We try, particularly in the more sustainable type strategies and the impact-aligned strategies that we run, we try to do a lot of our investing in the primary market. As an example, our impact-aligned strategy has approximately 60% of the fund purchased in the primary market. We're very, very active in the primary market. We see this as a very impactful way of investing.

Mike Reed:  19:19
That's really interesting to hear about how you influence things. I'd like to go a little step further, and try if you can, talk to me a little bit more about equity influence versus bond influence. I've heard the term ‘transition’ used a lot more frequently by asset managers over the last year. Can you explain what this means for bond investors and how they can encourage various types of issuers across the world to move towards a low-carbon economy, Tom?

Tom Moulds:  19:48
Yes, ‘transition’ is a word that's thrown around a lot. What we mean when we talk about transition is very much, well, the way I see it is the shift of investment strategies to support activities that contribute to reducing carbon emissions and promoting environmental sustainability, and also making sure that's done in the right way. Now, when it comes to doing this in public bond markets, I think there's a few things, I guess, to talk about.

One is that historically, I think a lot of ESG and sustainable investing has been very exclusionary. It's been, let's exclude part of our universe and the worst ESG offenders, and then we carry on. I think, there's a bit of a shift, and what we're trying to do here is actually have a more inclusionary approach. We're trying to focus on the solution providers to sustainability issues, to focus on the companies that are facilitating the transition, the companies that are transitioning themselves.

I think it's a hugely important role of bond markets to do that. More broadly, the whole fixed income market is actually larger than global equity markets. You can really understand the importance of having this mindset within fixed income markets. Now, clearly, there's actually some quite unique opportunities and ways to do this in fixed income markets. You're not just looking at public equities. Now, we've got access to government bonds and influencing governments, and also influencing private companies and companies that don't issue in equity markets.

There's a plethora of ways of having quite a unique influence here. We engage with governments on the government side, and we can really push the agenda there. Like I said earlier, I think engaging can actually have a huge impact in terms of making a big difference. I think some of the opportunities that we've had in the government-related securities and issuers have been super interesting, the SSA-type securities, sovereign-related bonds, agencies…the kind of issuers that are backed by governments but actually are very project led, whether they are vaccine programmes in emerging markets or bonds where the use of proceeds are facilitating some sort of progress in nature. We're seeing these things crop up now in bond markets.

We're very excited by that development and see more and more opportunities to be impactful across the whole breadth of fixed income markets.

Mike Reed:  22:33
I think that's great to hear. It's very interesting, I think, for listeners to understand that we're not just talking about public equities here and the reach that you have across governments, across private companies that raise money in the bond markets that you wouldn't see in the equity market. It's a much greater influence or sphere of influence that you possibly have there.

Finally, extending from that, I think it's a natural question to ask because there's been a rise in the issuance of ESG-labelled bonds in the fixed income market, as a way to encourage issuers to adopt more sustainable activities and practices to secure funding. We have heard of terms such as ‘green bonds’ where the funding is earmarked for green projects, or more recently, ‘sustainability-linked bonds’, where issuers commit to meeting specific ESG performance targets. Can you share with us your views on this market development? Are these a simple one-stop-shop solution for investors as they look for ESG investments?

Tom Moulds:  23:27
Sure. Yes, I guess the simple answer is no, in terms of being a simple one-stop shop. I think it's a fantastic development in the market that you're seeing these sorts of instruments. You've got green bonds, social bonds, sustainable bonds, sustainably-linked bonds, where there are targets, and even transition bonds as well, linking back to the previous question.

There's lots of instruments out there, and that's great. The use of proceeds of many of these securities are earmarked for specific projects, and the projects tend to be sustainable, and they fit into the different categories. It's been evolving, this market. You need to be a bit careful. There are definitely a scale of good-labelled bonds versus maybe less robust-labelled bonds, and I think you just need to look below the surface there a little bit.

For example, is the use of proceeds actually refinancing a previous bond, or is there new money going to new projects? These sorts of things are obviously more impactful. Having a way of evaluating the quality of these structures, I think, is important. What we've tried to do, particularly in our impact-aligned strategies, is take a step back and actually focus a bit more initially on the sustainability profile of the issuers, as a first port of call.

When we're looking at corporate issuers, in particular, we're saying what is the economic activity of that issuer, and does it align with a sustainability theme that we deem to be important? Also, are they doing enough of it? We want the majority of the issuers that we're looking at to be sustainable or aligned with one of our themes, so 50% in revenues or 50% in profits. I think that way it removes some of the difficulty that you have when it comes to looking at labelled bonds.

Now, labelled bonds are also an extremely important part of this kind of transition process. I think our role as investors is just to make sure that those instruments are as robust as possible, that we engage in primary markets to make sure that they are as credible as they possibly can be and provide a really great instrument for investors to invest in, and that we can be confident that the money is being used on the project that we want it to be used for.

All these things are great. I think one of the big things we've seen as well is a huge explosion in these types of instruments in the European market, much more than the US. If you look at the percentage of bonds issued that are labeled in Europe, versus the percentage of bonds issued that are labeled in the US, the difference is huge. I think that's another thing that I would really like to see, is for that to increase in the US as well, and something that we’ll clearly be encouraging as time goes on. It’s a great addition to the market. We do really love these instruments and push to make them more credible and better and better. A big percentage of the funds that we invest in are in labelled bonds, and it's a trend that's going to continue into the future.

Mike Reed:  26:36
Yes, I think one word I'll take from there is ‘credibility’. I think you're right that you have to make sure these are issued on the right terms and the proceeds go to the right uses. I think the process that I know that you and My-Linh and the rest of the team work with, from a bottom-up sort of investing, researching, really helps drive that.

Anyway, thank you, My-Linh, and thanks, Tom. That was a really great discussion, enlightening. It’s a very, very complicated subject. I think some people find it difficult to look into, and I think you've lifted the lid on how we look at it in terms of bond investments. Thank you very much.

Tom Moulds:  27:13
Thanks, Mike.

My-Linh Ngo:  27:14
Thanks for having us.

Mike Reed:  27:15
Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. We'll be back next month, and I'll be joined by Polina Kurdyavko, our Head of Emerging Markets, an area that seems to be generating a lot of interest from our clients right now. Thank you once again for joining us today. Good luck and goodbye.