We believe that investing responsibly in fixed income can be crucial for pension schemes looking to achieve either financial or sustainability objectives.

Responsible investors cannot ignore fixed income assets

Pension schemes value fixed income for its ability to help hedge interest rate and inflation risks, and for the contractually defined returns that fixed income instruments offer. A focus on contractually defined returns has become a growing trend for maturing pension schemes: as they approach their endgame, schemes pay out more in pension income than they receive from investment returns and sponsor contributions, making the contractual income from fixed income a key component of their strategy.

The role of these assets in portfolios, and their dominance across global markets, mean these assets cannot be ignored as investors seek to invest responsibly in pursuit of their goals.

Assessing debt issuers’ sustainability is vital for investors

The core focus for fixed income investors is the risk of an impairment to their coupons or return of principal. Any material risk that could affect whether an issuer fulfils these obligations – including Environmental, Social and Governance (ESG) risks – will be relevant to investors’ analysis.

Acknowledging the significance of ESG risks is broadly recognised as a central pillar of a responsible investment approach, and reflects a fixed income investor’s natural focus on the sustainability of an issuer’s operations and its ability to afford financial obligations.

For example, for pension schemes with defined pension obligations, maximising the certainty of achieving their specific target outcome is key. Investing with precision, including analysis of ESG risks to help ensure accurate valuations and effective risk management, is crucial.

The potential materiality of ESG risks is widely acknowledged. There are many examples of such risks having a material impact on the pricing of a bond, or leading issuers to default.

Bondholders can have far-reaching influence over governments and companies

Fixed income investors may seek to engage with debt issuers to better understand the ESG risks they face, how they manage them, and in order to encourage them to improve their practices.

When it comes to engagement, headlines typically focus on the power of shareholders who have voting powers that enable them to influence and, if necessary, replace, company executives. The reality, however, is that fixed income investors’ influence can far outstrip that of equity investors, primarily due to a range of institutions dependent on debt capital markets for financing.

Debt markets provide finance to a wide range of entities, including sovereigns, supranationals and agencies, as well as many companies, some of which prefer to raise finance using the debt rather than equity markets.

This means that fixed income investors can have influence on entities and market sectors that are inaccessible to other investors.

Opportunities for dialogue are often regular. For many institutions access to finance from the bond market is an ongoing necessity, either to fund new projects or roll over existing debt. This stands in contrast to the equity market, where issuance is comparatively rare.

While for major debt issuers a single investor or asset manager can sometimes have little effect, collaborative initiatives – where investors work together to achieve a common goal – can have a meaningful impact.

This means fixed income markets can play a central role for investors seeking to influence governments and corporates, whether that is to achieve their financial or sustainability objectives.

Bondholders can pursue precise sustainability targets

When debt is issued, fixed income investors can influence the structure and terms of the issuance. The regularity of debt issuance, combined with investors’ ability to influence the terms and structure, mean fixed income assets offer the potential for meaningful influence.

Investors can target sustainability outcomes in a way that other asset classes – such as equities – cannot offer.

In the now mainstream ‘use-of-proceeds’ bond market, issuance can be linked directly to specific projects with a positive environmental and/or social impact. The growth of this market means that debt issuers across a wide range of markets and sectors, including sovereigns and private companies, are being encouraged to pursue explicit sustainability objectives.

It also means that, through fixed income markets, investors are able to tailor their portfolios and objectives to reflect both financial and sustainability targets in new, innovative ways – more than other financial instruments.

New opportunities are yet to emerge

A responsible approach to fixed income, taking ESG risks and factors into account, can support an investor’s financial and sustainability objectives. This is now widely appreciated by investors, but there is still work to be done to refine what this means in practice.

Fixed income markets encompass a wide range of issuers and instrument types. While the basic principles of a responsible investment approach will remain consistent across them, the practical implications will be different.

Overall, investors are at the beginning rather than end of their journey with respect to integrating a responsible investment approach into their fixed income portfolios. However, as investor practices evolve, the focus on ESG risks and sustainability factors could provide investors with further opportunities to build portfolios that can target both financial and sustainability targets with greater precision, creating better outcomes for all stakeholders.