Credit and sustainability: ignorance is risk

investment viewpoints

Credit and sustainability: ignorance is risk

26 juin 2019

Yannik Zufferey, PhD

Chief Investment Officer, Core Business

Leslie Leigh

Client Portfolio Manager

The need for companies to adapt to long-term structural trends is not new. They have been doing it for centuries. However, today the challenges created by sustainability are more urgent than ever. In particular, sustainability-driven change is unparalleled in scale and speed.

Amid this sustainability revolution, we believe it is vital to adapt the way we invest in fixed income. In corporate bonds specifically, we believe sustainability must be taken into account as a key factor to mitigate risk without compromising potential returns¹. As such, we have developed a bespoke method to assess which companies are well-positioned to benefit from sustainability-driven change.

Since return in corporate bonds hinges on creditworthiness, we evaluate the robustness of borrowers through the prism of sustainability. We have developed a proprietary approach designed to identify companies with sustainable financial models, business practices and business models.

Our core principles to integrate sustainability into corporate credit portfolios

Integrating Sustainability into Corporate Bonds_V2.jpg (Integrating Sustainability...

Target performance/risk represents a portfolio construction goal. It does not represent past performance/risk and may not be representative of actual future performance/risk.

Our approach is based on these core principles:

Focusing on credit quality to embed a greater degree of safety - this allows us to improve diversification and better protect portfolios during periods of volatility.
Further mitigating risk by assessing extra-financial factors including environmental, social and governance (ESG) criteria and beyond - this means we favour companies with better business practices, and those we believe are evolving towards more sustainable business practices and models.
Considering the resilience of the portfolio to the physical and transition risks associated with climate change - this leads us to prioritise companies with a lower carbon intensity to reduce the carbon exposure of the portfolio, and add exposure to climate-aligned bonds.

In our view, issuers with better business practices, lower carbon intensity and a willingness to issue climate-aligned bonds are also more likely to transition to a low-carbon economy in an orderly fashion.

Stewardship and creditworthiness

We place great importance on being active stewards with debt issuers, and believe the characteristics of corporate credit lend themselves especially well to stewardship. In particular, engaging in dialogue with companies is critical to assessing creditworthiness because it improves our understanding of the issuer’s risk profile.

Traditionally, as owners of companies, equity investors have taken the lead on stewardship since they are directly impacted by the failure to manage or mitigate corporate governance risks. Bond holders engage with companies on different issues, however, because, as credit providers, they are more focused on preserving capital while earning interest. Because of this focus, key areas of bondholder interest might include leverage, liquidity and tail risks - such concerns become exponentially more significant for lower-rated issuers.

In our view, bond investors can influence companies towards more sustainable behaviour because of their role as providers of finance.

In our view, bond investors can influence companies towards more sustainable behaviour because of their role as providers of finance. This is particularly the case when new issues are brought to the primary market, and for smaller companies. Furthermore, non-investment grade issuers tend to have less balance sheet flexibility to absorb unexpected deterioration in their businesses due to material ESG risks.

A number of studies² have demonstrated that, on average, companies with a clear management focus on sustainability have been able to reduce financing costs compared with companies where this is less of a priority. Typically, the credit premium required by investors will be lower for companies that boast a strong sustainability profile. This would suggest a nascent trend for risk and return to be correlated with sustainability.

A 2018 report by Japan’s Government Investment Pension Fund (GPIF) and the World Bank³ argues bondholders may actually be more powerful than equity holders in encouraging companies to transition to more sustainable models. Because they can decide not to reinvest at maturity or to reinvest only at a higher rate, bondholders can directly affect the cost of debt.

Sustainability is upending the investment landscape. It can no longer be ignored as a key variable in any considered analysis.

sources.

¹ Target performance/risk represents a portfolio construction goal. It does not represent past performance/risk and may not be representative of actual future performance/risk.

² Deutsche Bank: Sustainable Investing, Evaluating Long-Term Value and Performance, June 2012.

³World Bank/GPIF: Incorporating Environmental, Social and Governance (ESG) Factors into Fixed Income investment, April 2018.

important information.

For professional investor use only

This document has been issued by Lombard Odier Funds (Europe) S.A. a Luxembourg based public limited company (SA), having its registered office at 291, route d’Arlon, L-1150 Luxembourg, authorized and regulated by the CSSF as a Management Company within the meaning of EU Directive 2009/65/EC, as amended.

Lombard Odier Investment Managers (“LOIM”) is a trade name.

This document is provided for informational purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This document does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipients exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. The contents of this document are intended for persons who are sophisticated investment professionals and who are either authorised or regulated to operate in the financial markets or persons who have been vetted by LOIM as having the expertise, experience and knowledge of the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue. The information and analysis contained herein are based on sources believed to be reliable. However, LOIM does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.

Source of the figures: Unless otherwise stated, figures are prepared by LOIM.

Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.

No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Funds (Europe) S.A prior consent.