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Sustainability Perspectives

Episode 55: How To Invest Sustainably In Fixed Income: Going Beyond Labeled Bonds

What are the key tools for sustainable investing in fixed income? Learn about the sustainable megatrends and methods for identifying themes that are actually investable (going beyond sustainability bonds).

Guest speaker: James Rich, senior portfolio manager of Sustainable Fixed Income at Aegon Asset Management.

  • Keesa Schreane [00:00:00] Welcome to the Refinitiv Sustainability Perspectives podcast, where our goal is to engage and inform our audience. From investors, to asset managers and portfolio managers, to sustainability leaders and those involved in ESG and sustainable finance. This is Keesa Schreane. Today, we're going to talk about the best strategy for sustainable investing in fixed income. We've talked a lot about labeled bonds in our previous episodes, but there are other fixed income tools to explore. Here with us is James Rich, Senior Portfolio Manager of Sustainable Fixed Income at Aegon Asset Management. James, thank you so much for joining us.  

    James Rich [00:00:41] Thanks very much for having me here. I'm excited to be here.  

    Keesa Schreane [00:00:44] So, James, I know that you believe that Sustainable Development Goals, or the UN SDGs as they're called, are a guide and not necessarily a blueprint, designed especially for investors. So with that said, how do you direct capital towards sustainable issuers and asset classes? Are you starting with the SDGs? Are you looking at other frameworks?  

    James Rich [00:01:06] Yeah, it's a great question. And the answer is we do start with the SDGs. What we find is that they're actually helpful in identifying some of the long term sustainable megatrends that we're trying to invest alongside of in a fixed income context. And so they're useful in that respect. I mean, they're widely recognized and people know what they are and they understand what they are. And so they're helpful to kind of identify some of those megatrends. The problem with the SDGs though, is that they were designed for policymakers and not investors. So the quote, investability, end quote of the SDGs varies greatly from SDG to SDG. And the targets often are sort of not even investible in any way, shape or form. So, you know, just to give you an example, SDG number seven, which is affordable and clean energy, is highly investable. There are lots of ways within a fixed income portfolio to invest in renewable clean energy. But on the other hand, SDG number one, which is no poverty, is more difficult to invest in in a fixed income context, and that is that there are few opportunities to invest in for profit companies that have issued fixed income securities that are helping bring people out of poverty. And so, like I said, what we do is we use the SDGs to help us identify some of these longterm sustainable megatrends that we think have staying power. But ultimately, you need a proprietary research process and you can't rely on the SDGs to kind of help you build an investment portfolio within fixed income. You have to go out and scour the markets to find specific investment opportunities.  

    Keesa Schreane [00:02:45] So great information, particularly about the SDGs are really being more for the policy making. And you know what, we're going to get into those megatrends in a moment, but first of all, just to set the stage, how do you personally define sustainable investing or sustainable finance, for that matter?  

    James Rich [00:03:00] Yeah, so sustainable investing or as we call it, at [00:03:03]Agan. [0.0s] Sustainable themed investing is part of a variety of responsible investment solutions that we provide to our clients. So there's four main types of products. One is exclusion based products, which is where a client comes in and says, hey, I want you to avoid sector X, Y and Z. There are best in class solutions where you're actually looking for companies with the best business practices within each sector to invest in from a responsible investment or an ESG integration perspective. Impact investing, which is where you're actually trying to generate measurable environmental and or social impact and then sustainability themed which is what we're talking about here today. And really the idea behind sustainable themed investing is aligning portfolios, and obviously we're talking about in a fixed income context, but it applies to equities as well, aligning portfolios with long term sustainable initiatives or as I said, megatrends, as a potential source of alpha for the portfolio.  

    Keesa Schreane [00:04:09] Great, so along with the alignment of the themes, you talk about something that I found really interesting, the sustainable domino effect. So let's start with how that happens. What's driving an increased focus on the sustainability theme investing in your opinion and how does that domino effect happen?  

    James Rich [00:04:26] Yeah, and this is really why we actually think that there's a real case to be investing sustainably and it's good to be investing in sustainable themed strategies. So basically, at the core of it is that we believe that there's an ongoing secular shift towards a more sustainable global economy. If you think about consumers, just as an example, the focus on sustainability challenges today, in our opinion, has never been higher than it is than really ever at any point in history. So things like climate change, which I think have been well publicized over the last, you know, five to 10 years, clearly there's a lot more focus on it today with the Biden administration in office here in the United States. But then things like, even on the social side, things like racial and income inequality really came into focus in 2020 and even more so in 2021 as we get into the new administration, there's a lot of focus on these sort of changes and these sustainability challenges. So, yeah, your point on, we call it the sustainability domino effect and it starts with consumers. So consumers are changing the way that they're shopping. And we've seen studies where two thirds of consumers are actually willing to pay more for a sustainable good versus a product that they actually believe is unsustainable. So consumers are actually, you know, they literally want sustainable products. And we also saw millions of people marching in support of the Black Lives Matter movement in 2020, which just shows, you know, sort of the focus on these issues, as I said, has really never been greater. The result of that, and a second domino to fall in this domino effect, is that governments have no choice but to respond with policy. You're seeing that with the Biden administration today with having a climate czar and rejoining the Paris agreement and having executive orders that he signed in the first couple of weeks in office supporting climate change and trying to reverse and counter it. But it's been happening for years. Take in China, there's emission standards that were put in place a few years ago, the six emission standards that require the emissions from automobiles to be cut by 50 percent from 2017 to 2023, which is reshaping entire sectors, and in that case in particular, the auto sector. So then the third domino to fall is businesses. Businesses have no choice but to respond to shifting consumer tastes and demands for sustainable products and policy that's coming out of governments. They have to adapt and they have to evolve or they won't survive. And then the last domino is investors, and that's obviously what we're talking about here today. We think that increasingly people are interested in investing alongside of this sustainable megatrend. And we also think that there's Alpha in doing so.  

    Keesa Schreane [00:07:25] So let's talk about the megatrends. I really want to start in context of those four dominoes, if you will, are megatrends decided by the consumers or are megatrends decided by the governments in terms of creating the policy? Is it the business decides? Who decides what those megatrends are? Were they just researched by the big investment firms that have those research arms, or do they come up with them some other way? And then we can get into what the megatrends are. 

    James Rich [00:07:50] Yeah, megatrends can really come from any of those areas. So like I said, you know, consumers wanting sustainable brands is forcing companies and businesses to rethink the products and services that they're offering. Governments changing the regulation around auto emissions is forcing the auto industry to focus on electric and hybrid vehicles and advanced biofuels as ways to power cars. And, you know, so it can come from any number of those sources. It's really a variety of different ways that, you know, sort of a sustainable trend. Ultimately, our job as investment managers is to identify those trends regardless of the source, regardless of if it's coming from the consumer side or the policymakers side, and to identify those trends and then find ways to invest our clients capital alongside of those trends so that our clients can benefit from them.  

    Keesa Schreane [00:08:42] Excellent. Very clear. So in terms of what those megatrends are, is that something you can highlight in terms of a handful of things that now we're focusing on?  

    James Rich [00:08:51] Absolutely, yeah. So we organize the sustainable megatrends into five sustainability pillars; climate change, eco solutions, resource efficiency, health and wellbeing, and sustainable growth. And there's a whole host of different sustainable megatrends that we've identified under each one of those sustainability pillars. But I'll give you a couple of examples. One is I mentioned this push from a policymaker perspective to reduce the emissions out of automobiles is forcing a trend towards hybrid and electric vehicles, particularly driven by China, which is the largest auto market in the world today. Not that the United States doesn't have its own emission standards and the EU at the same. But when the largest auto market in the world is changing emission standards, it's forcing the OEMs and the autoparts suppliers in every part of the auto  value chain to move towards hybrid and electric vehicles or advanced biofuels, which is another way to meet those emissions targets. So that's one example. Another one I mentioned is the social element, just the focus on the Black Lives Matter and social and racial inequality. Financial inclusion is something that we're seeing increasing focus on from a financial services perspective. And so that is providing affordable, basic financial services like banking and insurance to lower and middle income groups who maybe don't have access to those or haven't had access to them at the same levels as those of Americans and others who have had access to that, you know, for the majority of their lives.  

    Keesa Schreane [00:10:28] And if you're looking at the megatrends, my immediate thought was from the President Biden and the Build Back Better campaign that he ran on, that he continues to build out with Vice President Harris, in terms of the administration, if we look at these megatrends in context of building back, we could think about infrastructure, right? We could think about energy. Do you think one of those would fall into the megatrends very clearly from a build back perspective if we're just looking through that lens?  

    James Rich [00:11:00] Absolutely. I think if you think about, like I said, one of the key tenets of Biden's campaign and of his administration is going to be focused on climate change. One of the ways that you focus on climate change is by building infrastructure and power and industry back in a way that supports the fight against climate change and supports adaptation from a climate change perspective. So absolutely, there's no doubt that infrastructure projects, renewable energy projects, are going to be a part of the economy more and more going forward in the wake of the Biden administration.  

    Keesa Schreane [00:11:41] Great. Now let's talk about, again, sticking with the trends and the themes, I really want to get into investible themes, so equity shareholders have a different way to voice their desires, if you will, than fixed income investors. How do you identify themes that are actually investable within the fixed income universe and themes that respond to those desires of the fixed income investor specifically?  

    James Rich [00:12:04] Yeah. So like I said, you're identifying these megatrends, you know, like I mentioned, sort of hybrid electric vehicles as one, financial inclusion is another, then what we do is we go industry by industry and issuer by issuer and look for specific issuers that have some degree of alignment with one or more of those sustainable megatrends. So what we do at Aegon is we actually characterize every single one of our issuers into one of five categories. A leader, an influencer, an improver, neutral or detrimental. And for our sustainable themed strategies, like sustainable fixed income, the leaders, influencers and improvers are investable and everything else is not. And then what we do is we go through each one of those investment opportunities, we categorize it into one of those five buckets and then we make a determination as to whether or not it's eligible from the categorization system.  

    Keesa Schreane [00:13:11] Great. So in terms of kind of wrapping that up into the sustainable, the leaders versus the improvers, just curious as to what would validate, and if I have a company, if I think that I should be a leader as opposed to an improver, what sort of data points are you looking at? And how do we know for certain that one is an improver versus a leader? Because I'm assuming your categorization can make a huge difference in terms of how you invest, obviously, and how the general public thinks about the firm.  

    James Rich [00:13:41] Yeah, it's a great question. And ultimately, it's our prerogative as the investment manager to make that determination as to whether it's a leader, an influencer, an improver. But you're right, it does matter. The other thing that's interesting to point out is that depending when you think about multi-sector fixed-Income, each particular issue or type is different. So a corporate issuer is very different from a structured or a securities issuer, which is very different from a sovereign issuer or a municipal issuer. So for every type of issuer, we have to come up with a proprietary way to actually categorize the issuers into one of those five categories; leaders, influencers, improvers, neutral and detrimental. But we actually believe, to your point, there are really important reasons why both leaders, which would be a company that's later on in its transition and in fact is actually truly industry leading from a sustainability perspective to be in our portfolio, as well as improvers, which are earlier on in their sustainability transition and maybe have made a commitment to it, but haven't actually finished making that full transition to be sustainable.  

    Keesa Schreane [00:14:51] And so we're looking at the categorization there regarding those categories; leaders, improvers, et cetera. And I want to look at the categories related to these sectors. And if you take a similar approach in terms of corporates and then sovereigns and then the securitized debt, do you look heavily in one particular area? Do you find that there is opportunity that is across all of those areas, or what is the thought behind how we look at the sectors?  

    James Rich [00:15:16] Yeah, so for each type of issuer, let's just take corporates for example. Typically what we will do, is we'll look at the percentage of revenues that are aligned with one or more of the sustainable initiatives or those sustainable megatrends that we talked about earlier on. So we're looking for the revenue alignment. How much of the company's products and services are actually aligned with those sustainable initiatives? And then that revenue percentage helps us categorize whether it's a leader and influencer or an approver. When you look at a structured or securitized vehicle, it's a little bit different because they don't have revenues. It's a pool of of assets. It's a pool of collateral, essentially, and in many cases, its a fixed pool of collateral. There what we typically would do is look at the percentage breakdown of the pool of collateral. And again, it's not revenues, but it's assets looking at how much of that pool of assets is aligned with one or more of those sustainable initiatives. And then using that to put it into one of those five categories; leaders, influencers, improvers, neutral and detrimental. And then sovereigns, it's even more different than the corporates and the structured. There we're looking at capital usage, how effective the government is, how good they are representing the people's interests. Is it a free economy? You know, a variety of different metrics, both from a qualitative and quantitative perspective to determine ultimately how aligned the sovereign government is and the policies that are in place with long term sustainable initiatives. So a really different, it kind of differs according to the type of issues that you're looking at.  

    Keesa Schreane [00:17:00] Great, so that type of visual really leads to the thought process around which approach to take. James Rich, great conversation. I'm really starting to think about how sustainable investing is defined. Start with exclusion based products versus best in class, those products that really focus on responsible investing. Then there's impact investing and then finally, sustainable theme investing. One of the very interesting points around the sustainability domino effect starts with the consumers changing the way they're shopping, then the government's responding with policy and finally the businesses making the shift and investors. And the megatrends can come from any of these sources. James, great conversation. Thanks so much for sharing your insights.  

    James Rich [00:17:41] Thank you for having me. I enjoyed it.  

    Keesa Schreane [00:17:44] We invite you to subscribe to the Refinitiv Sustainability Perspectives podcast on iTunes, Spotify or wherever you stream your content. What did you think about the podcast? Leave us a review on iTunes or follow us on LinkedIn and Twitter for updates on our show, you can even check us out on YouTube now. Thank you for joining us. See you next time.