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Fixed Income engagement - where is the impact?

Everybody talks about it, but few actually get involved

 April 2019   |    Share this article

Thomas Bjørn JensenThomas Bjørn Jensen
Senior Portfolio Manager, Fixed Income Team, Sparinvest
tbj@sparinvest.dk
Antonia DraghiciAntonia Draghici
Analyst, Fixed Income Team, Sparinvest
adr@sparinvest.dk


For every engagement undertaken by Sparinvest’s Fixed Income team, the focus is on reducing downside risk for bondholders. As active and ESG-aware bondholders, we aim for positive change through constructive dialogue with issuers. In doing so, we are able to show companies that their interests are aligned with ours, and both can benefit. This can result in better returns, while making the world a better place. Companies rely on corporate bond issuance to finance their goals for the future, which provides bondholders leverage when it comes to influencing corporate behaviour. So why aren’t more bondholders flexing their muscles?

Speed read

  • Sparinvest has first-hand experience that companies will respond to constructive dialogue on ESG matters
  • In order to convince a company to adopt change, you need to be able to show the benefits that change will bring
  • It is important to show companies that – if they need to borrow money for future projects - their interests should be aligned with those of the bondholders

Sparinvest - a pioneer of sustainable investing

There are many ways for a company to obtain financing. Traditionally, banks were the main source for companies in need of capital but in the past decade, companies have increasingly issued debt securities (bonds) as a means of obtaining finance from investors. Corporate bonds are traded publicly on fixed income markets – in the same way that equities are on stock markets. They offer the investor the prospect of a fixed rate of interest over a defined period, with repayment of the loan at the end, provided the company remains in business.
According to 2018 PRI statistics, 73 percent of Fixed Income signatories are now engaging on ESG issues. So why hasn’t the corporate world felt the impact yet? Why is it that Corporate Governance codes, designed to encourage active ownership by investors do not cover Fixed Income securities? ShareAction, the charity that promotes Responsible Investment, recently published research showing that large bondholders were ‘sleeping giants’, with little appetite for forceful engagement - as evidenced by their marked failure to join the most important Responsible Investment industry initiative on climate change to date - Climate Action 100+.

By failing to act in unison, and missing obvious opportunities like these, bondholders are missing the chance to influence sustainability. 

However, one bond team that is really ‘walking the talk’ when it comes to Fixed Income engagement is the Corporate Bond team at Sparinvest. We undertake a combination of direct, collaborative and service provider engagements. We joined Climate Action 100+ at our own request. Below we explain why we do it and give a candid description of the possibilities and limitations of bondholder engagement on ESG issues.

Rule number one - to get attention, be constructive

Bond issuance is an essential borrowing mechanism for companies needing to finance operations and future growth. Clearly, from this perspective, as the principal buyers of corporate bonds, Fixed Income fund managers have the potential to influence the behaviour of companies that need their money. Such influence could be all the greater if institutional bondholders were to act in an orchestrated way, joining or forming collaborative engagements in the same way that institutional equity owners do. Yet current evidence suggests that bondholders aren’t engaging – either individually or collaboratively. There may be numerous reasons for this – particularly in times of monetary stimulus like the present, where investment funds are plenty, and asset owners are all begging for return. In such times, profitable companies are not forced to listen. So perhaps this makes bondholders reluctant to start the conversation at all.

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To adopt such a defeatist attitude is not only unhelpful to the sustainability cause, it is also misguided. Bondholders are able to achieve impact, and the best way for them to do this is through constructive dialogue. In a busy world, where companies have to prioritize, the regular requirement to face AGMs, where Management policies (and salaries) are put to the vote, often means that shareholders are put at the top of the agenda. But we know from experience that the bond issuers that we invest in will listen to us as bondholders when we approach them with ESG concerns.

Not being able to force change on a company through voting leaves dialogue as the only option. But if the dialogue is based on the desire to be constructive and helpful, it can grab attention. Constructive dialogue requires thorough analysis and, not least, patience. In order to convince a company to adopt change, you need to be able to show the benefits that change will bring – ideally both from an ideological and economic point of view. In order to get (and maintain) the attention of the company, you need to be able to pinpoint exactly the direct and indirect additional value to be gained from the proposed changes. Refraining from subjective and emotional statements and sticking to facts is also a key element in a constructive dialogue.

The likelihood of achieving impact increases the closer you can get to a company and creating a close bond usually also entails on-site meetings, but again it adds to the resource drain. Building a reputation for coming with constructive input is also a key driver of successful engagements with the target company.

Multiple stakeholders make multiple demands

In business today, companies rely on numerous stakeholders to contribute to their profitability/good reputation. All stakeholders have tools at their disposal to exert an influence on companies, enabling them to recover loans, secure goods/payment/profits or change products or corporate behaviour.

Depending on where we are in the economic cycle, there may be times when the company needs to prioritize some stakeholders over others. But in the end, they all have a chance to influence.

Stakeholder type Tools of Engagement
Customers Able to buy competitor products / boycott / make social media campaigns
Regulators Able to impose taxes, tariffs, laws and guidelines
Banks Able to recall loans – even where repayments have been on time
Suppliers/leasing Companies Able to end contracts / refuse further business / strike deals with competitors
Shareholders Able to vote on company proposals at General Meetings. Able to leverage ‘ownership’ to hold dialogues with Management. Three types of possible engagement - direct, collaborative and indirect - via a service provider
Bondholders Able to use position as a debt investor to enter dialogue, especially where the company is likely to issue repeat bonds, or in a restructuring. Three types of possible engagement - direct, collaborative and indirect - via a service provider

In recent years, influencing company behavior has extended from being the preserve of shareholders to involve virtually all the stakeholders of a company. Regulators and industry standard setters have moved beyond basic prohibitions and tariffs to becoming much more active in implementing guidelines for good corporate behavior. We have witnessed how consumers have evolved in their buying habits and awareness. No longer do they simply buy things off the shelf or on a whim. They seek and demand a high level of transparency from manufacturers, regarding the supply chains and ethical standards, environmental responsibility and so on.  Companies can no longer rely solely on shareholder-friendly activities. They now have to listen to feedback from all stakeholders. 

Engage - reduce risk and increase return

Bondholders have multiple incentives to become active owners. Beyond any commitment to abide by the commonly-adopted responsible investment principles, bondholders also have the opportunity of enhancing the financial returns from their investments. We believe that achieving both goals is actually possible, but, counter-intuitively, it may mean that when selecting companies for engagement, one should actually opt to hold dialogue with the comparatively worse behaved from an ESG perspective or with companies that are using resources inefficiently. In other words, there is more to be gained from engagement where there is obvious room for improvement in corporate behaviour. So, from an impact point of view, best-in-class companies, are less relevant for an engagement strategy that seeks to make the world a better place or to enhance returns, or preferably both.

We have also learned from our long history of equity engagement that certain types of companies may be more predisposed to enter engagements to learn more about how they can benefit/improve. These can include smaller companies, companies wanting to be included in specific indices, and companies that have previously been unaware of the increasing investor focus on sustainability.

Intuitively, it makes sense that a company focused on reducing the risk of doing business, or on enhancing revenues from ‘doing the right things’, would see a positive impact on corporate value. It is the risk of doing business, hence downside risk, that is paramount for bondholders - not the potential upside. Compared to the share price of a company that can multiply numerous times, the price of a bond has a limited upside – but both can go to zero. Effectively, that means that a loss on one bond cannot be covered by the profit of another, as could be the case with shares. That emphasizes the focus on downside risk for bondholders, where issues stemming from ESG can have a significant impact. ESG risk is significant for companies as well. In a worst-case scenario of an environmental or human rights disaster, it could lead to them losing their license to operate. This is why it is important to show companies that – if they need to borrow money for future projects, their interests should be aligned with those of the bondholders.

Demonstrably reducing the risk of doing business will enable the company to obtain better terms and conditions on its financing needs, as bondholders will then be willing to lend out money at a lower credit premium. It should also be noted that improved ESG profiles for bond issuers could lead to better ratings from the credit rating agencies who now also integrate ESG considerations as part of their rating process. For existing bondholders, this means that the market will accept a lower yield; hence, the return on the bonds will increase. Although very difficult to measure in real life, several academic studies confirm that this is the case*. 

 

Building an engagement strategy is key

Interactions between investors and companies on ESG issues are known as engagements. Before initiating an engagement, it is essential to have a clear strategy on what the goals are and how they can be accomplished. The ambition level should be balanced with the ‘stakeholder toolbox’ and the resources available.

Goal setting needs to be realistic, and closely aligned with the investment strategy. For bondholders, goals should also be achievable within a timeframe that does not exceed the maturity of the bonds in focus.

As we already addressed in the previous section, different toolboxes are available to different stakeholders. The bondholder toolbox contains three engagement options: direct, collaborative and indirect. The first approach implies direct and bilateral interaction with the company, typically with their Investor Relations or Management, depending on company size. Direct engagement is extremely time-consuming, especially when it aims for constructive and thorough dialogue. The collaborative engagement method entails setting up a group of like-minded investors and/or organizations arguing for the same issues, hence presenting the company with a unified voice, backed by a greater number of creditors. This approach is usually less time-consuming for the individual bondholder, depending on whether they take on a leading role in the collaboration or a supportive one. Nevertheless, there is a requirement to agree with the other investors in advance on the objective, communication content, timeline, and so on, which can be something of a compromise. Indirect engagement is when bondholders outsource the engagement to a third party service provider; a company specialized in engaging on behalf of a larger group of stakeholders. 

It should be noted that both collaborative initiatives and service provider engagements are still much skewed towards the interests and participation of shareholders.

The basic characteristics of the company play an important role in deciding on the engagement approach. The bigger the target company, the more difficult a single investor may find it to be heard, suggesting that collaborative engagement is the better option. On the other hand, the collaborative engagement may not provide you with the same degree of insight and may not be directly aligned with your specific goals. One should not underestimate the power of having/building personal relationships and direct access to the decision-making body of a company when it comes to being heard and achieving impact.

 

Escalation – the way to bolster the dialogue

When engaging with a company, we sometimes have to respect a decision by Management not to follow our recommendations and demands. If the company is able to prove our assumptions or conclusions wrong, and our recommendations are rejected – with the full knowledge and approval of both Management and the Board, we will usually suspend the engagement.

But if we disagree, or if we are not initially able to reach the true decision makers in a company, we will consider taking steps to escalate the matter. 

Our first point of contact will usually be Investor Relations, in order to follow the diplomatic route through the decision-making structure of the company. In many cases, this approach - directly or indirectly - will grant us access to Management. In cases where we do not obtain a meaningful response (or even any response) after a couple of follow-ups, we will usually reach out directly to Management and Board.

Unlike certain NGOs and consumer groups, we would seek to avoid the threat of public shaming as an escalation approach. We do not believe that negotiating with a knife to the throat, yields positive results. Acquiring a reputation for resorting to this approach could harm our ability to work successfully with other companies to achieve change.

When all attempts to get the necessary attention from - or find common ground with - a company are exhausted, and the risk of doing business with the company therefore remains undiminished, the last resort will be divestment. When choosing that option, we would always send an exit-letter explaining the motivation behind the divestment, and urging the company to continue their efforts to improve on the specific matters.

Ironically, we sometimes find that our divestment letters prompt the disclosure of significant information that can pave the way for a better future relationship.

Commitment is the best measure of successful engagement

In order to justify the resources allocated to active ownership, you need to document the results of engagements. You need to define the success criteria that will establish whether the engagement has been successful. As mentioned, implementing changes in corporate behaviour can be a lengthy process, and it may not always be possible to see the fruits of your labours before bonds reach maturity. Furthermore, you may not always have the resources available, or the first-hand insight required to monitor whether the necessary changes have been implemented – or whether they have been widely communicated. That could require – amongst other things - on-site verification visits. Fortunately, financial markets are forward-looking, and thus primarily driven by expectations and, to a lesser extent, by what happens here and now. Therefore, you need to create a valid and confirmed expectation of positive change in order to have the market factor in the anticipated benefits from the future change.

This can be done by encouraging the company to make a public commitment to the proposed changes, usually as a policy document signed by Management or the Board. Effectively, that will make them liable, both personally and economically if they do not fulfill the stated policy. In other words, we perceive the publicly stated intention and commitment to change as being the appropriate milestone for a bondholder to measure engagement success by, and not the actual change itself.

Everybody claims to be active owners, but…

Compared to a few years ago, it is difficult to find an investment manager today that does not claim to be committed to responsible investing, including active ownership and engagement. The challenge is that you will find as many approaches and definitions as there are investment managers. Some claim that responsible investing is all about screening out the worst behaved companies, some only select companies that are best in class, and finally some only engage via a service provider. However, it is our belief that - in order to implement sustainable change (change that helps both to make the world a better place for everybody and to generate healthy investment returns), it is essential to be both highly selective regarding individual investment decisions and to be ‘hands-on’ as active owners. You cannot just adopt a best-in-class investment strategy and hope that all the bad performers will disappear, just as you cannot rely on other peoples’ efforts to accomplish your own goals. 

Regardless of their experience, and the trillions of dollars of investments that they represent, target companies can still meet the demands of service providers with a deaf ear. Often their voices fail to be as powerful as those of direct investors offering a constructive viewpoint. The result is that companies can be slow - if not unresponsive - to their enquiries. If it is not done constructively, we do see a risk of diminishing the impact of active ownership as companies might eventually stop listening. We have found it powerful to collaborate with our service provider and sometimes contribute to the dialogue by reminding the target company of the importance to us as investors of the issues being highlighted on our behalf by the service provider engagement.

Active ownership is not an exact science

As we have highlighted, it is not possible to invent a fixed formula or structure when it comes to influencing companies. The approach will depend on the issue under consideration, the characteristics of the company we are dealing with, and the investment strategy of the fund (active or passive). Balancing these considerations is not an exact science, but practice makes perfect. We have learned that aligning interests, balancing a thorough understanding of the issues and conducting constructive discussions are essential for addressing each company’s risks of doing business. Sometimes we also learn which companies are unwilling or unable to improve – which is an important lesson in itself.  For those that are willing to adapt to the demands of responsible investors, we monitor any relevant indicators of change and, in particular, we view any commitment to address ESG issues as measure of progress. In the eyes of a bondholder whose focus is on protecting downside risks, any progress is good progress and, fortunately, the market is never too far behind in recognizing this.

Sparinvest has first-hand experience that companies will respond to constructive dialogue on ESG matters and work with bondholders to reduce the risks of doing business. But imagine how much more influential bondholders could be if they were to work more with companies on ESG or join forces to tackle major sustainability themes in the same way that shareholders do.


*Relevant academic studies:

Cheng, Beiting, Ioannis Ioannou and Serafeim, Corporate Social Responsibility and Access to Finance, Harvard Business School Working Paper, No. 11-130, June 2011, 
Bhojraj & Sengupta, Effect of corporate governance on bond ratings and yields: The role of Institutional investors and outside directors, Journal of Business vol.76, no.3, 2003, 
Gunnar Friede, Timo Busch & Alexander Bassen, ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, 5:4, 210-233, 2015
Oikonomou, Ioannis and Brooks, Chris and Pavelin, Stephen, The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings (February 2014). Financial Review, Vol. 49, Issue 1, pp. 49-75, 2014. 

The information contained in this article is not, and should not be construed as, a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction, or to provide any investment advice or other financial or banking service. The material has been prepared solely as a guide to you and your financial institution. There are always risks involved when investing and it is stressed that past performance or past return cannot be considered a guarantee for future performance or return. Sparinvest does not undertake any responsibility for the advice given and actions taken or not taken in respect of this material. Sparinvest makes reservations for possible typing errors, calculation errors and any other errors in the material.

Do you want to learn more about how we do ESG-reporting as an active and ESG-aware bondholder?

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