WHITE PAPER May 2015 For professional investors Integrating ESG criteria into fixed income investments Making better informed investment decisions Edith Siermann Integrating ESG criteria into fixed income investments 1
A strong advocate of sustainability investing Institutional investors are attaching increasing importance to the sustainability of their investments. Whereas in the equity space, this trend has been going on for years, in fixed income investments sustainability investing has only recently started to generate widespread interest. Robeco is one of the pioneers in integrating sustainability information into its analysis of both government bonds and credits. In this paper we will explain how we do this. As one of the first signatories of the United Nations Principles for Responsible Investment since December 2006, Robeco is committed to the integration of Environmental, Social and Governance (ESG) factors into its investment decision making and ownership practices. In that same year Robeco acquired RobecoSAM, a dedicated asset manager and recognized leader in sustainability investing (SI). RobecoSAM has compiled one of the world's largest sustainability databases based on its annual Corporate Sustainability Assessment (CSA) of over 3,000 listed companies. This database, which includes company profiles and financial materiality analyses, is exclusively available for Robeco s investment processes. Sustainability Investing well embedded within Robeco It is Robeco s conviction that sustainability is under-researched and has a material impact on performance. We are therefore convinced that taking financially material sustainable issues into account will lead to better informed investment decisions. The integration of ESG factors in the investment strategies is well embedded in the organization. Our fixed income portfolio managers and analysts closely cooperate with the engagement specialists from the Governance and Active Ownership team and the Sustainability Investing Research analysts at RobecoSAM. Figure 1 Integrated sustainability investing framework Engagement & voting Governance and Active Ownership Financially material themes Sustainability Investing (SI) Research - RobecoSAM Corporate Sustainability Assessment (CSA) - SI company profiles Portfolio managers & analysts ESG integration Source: Robeco Integrating ESG criteria into fixed income investments 2
Government bonds: ranking countries on sustainability In our government bond portfolios, the active country allocation is based on a combination of top-down and bottom-up analysis. In the bottom-up analysis, we focus on three key areas: debt sustainability, ESG factors and the economic cycle. Environmental, Social and Governance criteria are therefore an integral part of our analysis. RobecoSAM Country Sustainability Ranking For our top-down analysis, we use our in-house developed RobecoSAM Country Sustainability Ranking. Since 2009, Robeco fixed income funds such as our total return bond fund Rorento, Robeco All Strategy Euro Bonds and Robeco Euro Government Bonds have used this country sustainability analysis and the resulting ranking of countries as an integral part of their investment processes. This ranking is based on an extensive database for which we have selected ESG data that in our opinion are relevant for investment decisions. In practice this means that social and governance criteria have a larger weight in the ranking. The methodology was a joint effort of Robeco s Fixed Income department and RobecoSAM. Updated twice a year, it acts as an early-warning system which helps us to identify problems as well as opportunities in countries well before they are reflected in spreads, or are picked up by the rating agencies. Added value in practice Our practical experience is that the information from the RobecoSAM Country Sustainability Ranking has often proved to be a valuable addition to traditional debt analysis. Changes in the ranking act as flag for changes in the country profile that could be relevant for investment decisions. Apart from the ranking we discuss the individual countries on a regular basis, to identify material changes in their ESG profile. ESG factors are incorporated into investment decisions when deemed relevant. For instance we incorporate them into country allocation decisions, but not into yield curve decisions. For all investment decisions we write an investment thesis. In such a thesis the ESG risks or opportunities are a standard element. Figure 2 Ireland s ESG scores Source: RobecoSAM, March 2007 March 2014 Integrating ESG criteria into fixed income investments 3
Recently, for example, the Country Sustainability Ranking has helped us to better differentiate between euro area periphery countries. Within the periphery countries Ireland has stood out as a prime example of a country for which the ESG profile has improved. Areas where improvement has taken place are amongst others: the quality of bureaucracy, transparency of policymaking, public support for the government and CO 2 emissions. This broad based improvement has brought the ESG score back to the level of before the financial crises and close to that of a country like Germany. This is shown in Figure 2. This has helped us to better judge the risks of investing in Irish government bonds and partly drove our decision to increase investments in this market in spite of other risks like a lower liquidity in such a relatively small market. Figure 3 Country Sustainability Ranking Source: RobecoSAM A good example of a case in which an ESG score prevented us from investing in a country was Greece. The Greek bond market performed well in the first months of 2014 and a bond issuance in April and July was heavily oversubscribed. We did not participate, based on the lack of improvement in the Greek ESG profile. In spite of reform plans the country has continued to score poorly on factors like social unrest, effectiveness of government policy, corruption, quality of institutions and environmental risks. A visit to the country and meetings with policymakers confirmed this lack of improvement. Integrating ESG criteria into fixed income investments 4
S&P Dow Jones sovereign ESG index based on Country Sustainability Ranking On April 8, 2015, S&P Dow Jones launched the S&P ESG Pan-Europe Developed Sovereign Bond Index. This first ESG-weighted bond index from S&P Dow Jones is based on the RobecoSAM Country Sustainability Ranking. The starting point for the index is the market cap weighted index. Subsequently, the country s sustainability score in the RobecoSAM Country Sustainability Ranking and the change in this score are compared with the average score of the investment universe. The country score has a 75% weight and the change has a 25% weight. Based on the deviation from the average, the country s weight is adjusted. We see the fact that S&P Dow Jones now bases its ESG index on our Country Sustainability Ranking as a stamp of approval for our country sustainability analysis process. Integrating ESG criteria into fixed income investments 5
Credits: using ESG insights to better assess downside risk One of the cornerstones of the investment philosophy of Robeco s Credit team is that avoiding losers is more important than picking every winner. The team believes that integrating ESG factors into its analysis strengthens the ability to assess the downside risk of its credit investments. The credit analysts have access to the detailed proprietary research done by RobecoSAM s dedicated SI analysts. The latter write company profiles on the companies of the coverage list. These company assessments give an insight into the company from a sustainability point of view. The SI analysts have also drawn up materiality analyses for all major industries, which are the basis for their company specific ESG analyses. In return, the credit analysts share their sector knowledge to help the RobecoSAM SI analysts to further customize and improve questionnaires and research. Together they discuss all relevant ESG issues and when necessary, they team up to perform a sustainability analysis on certain sectors or companies. ESG is one of the five factors analyzed The primary concern of a corporate bond holder is the company s ability to repay debt. Key focus of Robeco s credit analysis is therefore the cash generating capacity of the issuer and the quality of the cash flows. The team performs this analysis through a fixed format assessment of five different variables of which ESG is one. The other variables are the company s business position, corporate strategy, financial profile and corporate structure. Based on these five factors the analyst assigns a fundamental score which expresses the overall fundamental view on a company for the coming year relative to its similarly rated peers. This fundamental score is the conclusion of an extensive company analysis report. In this report companies are compared with their peers in the industry and rating category. The fundamental score gives a conclusion on the relative quality and attractiveness of the bonds of a specific company and is discussed within a team of credit analysts and the portfolio managers as part of the bond selection process. The weight of the factors varies The five factors on which the fundamental score is based do not have a fixed weight; their relative importance differs per sector and per company. For instance, the business position is often quite important for companies with a solid credit rating that operate in competitive environment. Corporate structure however tends to have a bigger impact on high yield companies with often a more complex layered company structure and sustainability can contribute more negatively in the case of, for example, tobacco companies where sustainability risk is more crucial for the companies earnings. Higher risk associated with ESG can translate into lower fundamental scores. Integrating ESG criteria into fixed income investments 6
Figure 4 Credit analysis at Robeco Focus on downside risk Financially material issues Absolute impact matters Source: Robeco In the car industry, for example, manufacturers need to reduce CO 2 emissions, as cars are one of the main sources of man-made CO 2 emission. Car manufacturers are investing in R&D to reduce the CO 2 emissions of their cars. Although savings can be achieved in several areas, most of the efforts focus on the powertrain of cars. There are several types of innovation, such as hybrid powertrains or even fuel cell powertrains. As the required R&D spending will have a negative impact on the industry s profitability, this ESG risk needs to be compensated for by higher spreads. Another example of ESG developments influencing our credit analysis relates to the food industry. Food companies are forced to re-evaluate their product portfolios due to the rising concern over whether they promote obesity. In the credit team we examine the downside risk of this trend for the companies we cover. Earlier this year Robeco s equity analyst, credit analyst and RobecoSAM sustainability analyst joined forces to visit several companies in Switzerland to discuss obesity related ESG considerations. We evaluated how the food companies may be impacted in the future due to potential regulations, taxes on high calorie/high sugar products, fines, etc. As companies usually pass on price increases, products become more expensive, which can potentially impact sales. In our risk assessment, we try to gauge which companies are best positioned to address the challenge. We take into account criteria such as the number of reformulations and the part of the portfolio with high calorie/low nutrient products. While we do not necessarily refrain from investing in these companies, we examine how they may be affected in the future by changing consumer trends and whether spreads reflect the risks we perceive. Integrating ESG criteria into fixed income investments 7
The impact of the country sustainability score The ESG score of a country can also have an impact on the ESG score of its companies. A credit analyst therefore also takes the relevant country s sustainability score into account when evaluating a company. Many of the largest credits are multinational companies, so we have to drill down to see where the operations of these companies are located, and what the impact could be of any governmental issues on the credit. For this we need to look to see where the company s activities are concentrated, rather than where its head office is domiciled, and see if there are any areas where country factors could have an impact. For example, take two well-known companies with strong Dutch roots Shell and Unilever. Shell has problems in Nigeria - the headline risk there is improving, but has not yet been solved. Likewise, Unilever operates in more than 100 countries and it could be impacted by a government in an emerging market. This could feed through into a negative impact on the company if that country doesn t score well. Integrating ESG criteria into fixed income investments 8
A pioneer in engagement One of the ways in which Robeco integrates ESG factors into the investment processes is by exercising its investor responsibilities. This is done by Robeco s Governance and Active Ownership (GAO) team. With the engagement specialist from GAO the credit analysts discuss financially material themes or company specific issues to be addressed via engagement and research studies. In return, the GAO team gives valuable information to the credit analysts on the results of their discussions with management. This close cooperation helps the credit analysts get more relevant ESG data and knowledge on the companies in their sector. And an active engagement with listed companies has also proven to Robeco to be a useful instrument to influence corporate behavior. Whereas the GAO team also exercises its voting rights for Robeco s equity investments, there are no voting rights for credits. Nevertheless, also for fixed income investments it is possible to discuss important ESG topics in meetings with management. 10-year anniversary Robeco has been an active owner and has been voting and engaging its investee companies for ten years. Back when we started in 2005, we were a true pioneer in this field, and we have continued to be at the forefront ever since. Right from the start our active ownership activities were not driven by mere legal or compliance considerations. Instead, we had a fundamental conviction that we should be a responsible steward for the assets entrusted to us. We undertake our active ownership activities from an investor s perspective, aiming to add value to companies, on behalf of clients and for our own portfolio managers. External recognition Some of the results of the past decade were getting independent members elected on boards, and convincing senior executives of the need to incorporate issues such as carbon management, obesity and diversity into their business practices and company strategy. To push for results, we were involved in many meetings and various on-site visits throughout the world, including to oil wells in Nigeria and coal mines in India. Recently we focused on topical subjects such as corporate governance in Japan and stranded assets in the utilities space. Last year, the icing on the cake was that the United Nations-supported Principles for Responsible Investment (PRI) awarded Robeco top scores for its approach to active ownership, due to the systematic way in which we conduct, monitor and report on our voting and engagement activities. Exclusion only as a last resort Exclusions are for us the very last step in the process. We apply exclusions only to controversial countries, producers of controversial weapons, and to companies with consistent and not improving breaches of the UN Global Compact. We prefer to have an active dialogue with companies, encouraging them to improve their sustainability performance. Excluding them would deprive us of exercising our influence. Integrating ESG criteria into fixed income investments 9
Conclusion: better informed investment decisions Robeco is convinced that taking financially material sustainable issues into account leads to better informed investment decisions. In our government bond strategies, the active country allocation is based on a combination of top-down and bottom-up analysis. In the bottom-up analysis, we focus on three key areas: debt sustainability, ESG factors and the economic cycle. For our top-down analysis, we use our in-house developed RobecoSAM Country Sustainability Ranking. This ranking is used by S&P Dow Jones for its first ESG-weighted bond index, the S&P ESG Pan- Europe Developed Sovereign Bond Index. In our credit capabilities, it is our firm belief that avoiding losers is more important than picking every winner. Integrating ESG factors into our analysis strengthens our ability to assess the downside risk of our credit investments. To assess a company s ability to repay debt, we assess five variables of which ESG is one. In addition to the integration of ESG factors into the various fixed income investment processes, Robeco exercises its investor responsibilities by actively engaging with listed companies. We prefer this to exclusion, as it allows us to exert influence over the issuers of the credits in our portfolio. The UN-supported Principles for Responsible Investment (PRI) have awarded us top scores for our approach to active ownership. Edith Siermann Chief Investment Officer Fixed Income Important information This publication is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: 24123167) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com. Integrating ESG criteria into fixed income investments 10