Green bonds offer another side to ESG investing

-- | 05/03/2020

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Glenn Freeman: In this edition of how we invest your money, I'm speaking with Vishal Khanduja from the Boston offices of Calvert Research and Management, and we're discussing ESG.

Vishal, thanks for your time today.

Vishal Khanduja: Thank you. Glad to be here.

Freeman: Now, Vishal, ESG is often spoken about from the level of stocks and active funds, but not in the context of fixed income. Now, what do investors need to know about this?

Khanduja: That's a very true statement and it does not only apply to Morningstar. I think a lot of investors that we've spoken to, at least initially have approached ESG from an equity standpoint. I think from the fixed income perspective, most of the financially material ESG factors that you would look at it from an equity perspective, or what impact the valuation of a company overall would directly imply to – or apply to fixed income as well.

Fixed income allows you to express your opinions even further, rather than just holding or not holding a company, that's one choice. But then, you can hold a two-year bond versus a 30-year bond of a same company depending on what you think about from the ESG factors, what those factors are telling us about financial materiality.

You can own a senior bond versus a junior bond or a subordinated bond. You can own an asset-backed security versus owning a senior unsecured debt.

So, the way we think about ESG, yes, those are financially material factors directly affecting valuation of companies longer term, but then how do you express it in a portfolio can be also very different from what an equity investor would do. So, an equity investor's standpoint, you're either owning the stock, not owning the stock or you're overweight or underweight.

But you cannot buy a longer stock versus a shorter stock that you would do from a fixed income perspective.

And the last point there – I know I have taken up a little bit more time than allotted to this question – but in the fixed income land, you can also direct the proceeds of that fixed income bond towards an impactful project.

So, sometimes, some of our investors think about ESG as impact investing or green bond investing. So, that's the second layer of what fixed income differs from an equity standpoint where you can tell the company directly to use those proceeds for a particular project. That's our point.

Freeman: Now, Vishal, how do you actually choose the bonds that make it into the fund? Do you use a negative screen to exclude some?

Khanduja: So, we don't think about it as a negative screen. So, we don't start the investment process by saying that these are industries that we will never invest in. So, we start from the bottom-up where – and we have the luxury of having an in house ESG analyst team. So, just like you have credit analyst teams and we have those as well, we have a very deep bench of ESG analyst team. So, the ESG analysts…we have a dozen of those, 12 of them, who are broken up by sectors or they're focused by sectors.


So, there is an analyst who covers everything on the financial side and consumer finance and big banks, and so on and so forth, retail and energy, and that's how we differentiate them.

All these analysts are going and creating a thesis on what is truly important from an ESG factor basis for their sectors. And then, eventually, they create models and rate and rank companies within their sectors. That's how the bottom-up process starts, exactly how a credit analyst team would approach investing for their sector.

They look at their companies, create a model for those companies and then rate and rank those companies on how they are behaving or how they are changing to get better on the E, S and G factors which are material for their valuations long term.

At the end of all this, you will see that our portfolios are not investing in a lot of these energy companies because we think that a lot of these energy companies who are extracting oil or commodity heavy have a lot of standard assets below the ground.

Seeing now what is happening with oil prices, we think that has a very detrimental effect on their balance sheets and income statements longer term. We don't think that these companies have any optionality to move away. These companies cannot become renewable energy tomorrow.

Freeman: And finally, the performance of any fund is always top of mind for investors. And do you apply any performance benchmarks to your ESG funds?

Khanduja: We can talk about ESG investing, we can talk about fixed income global investing. But one part that sometimes gets missed out is my incentives, my team's incentives are based on us beating broader benchmarks. So, we take financially material information, apply it to the bonds that we are allowed to and that could go into the portfolio.

So, a lot of times, as you had asked that question, energy will not show up, tobacco will not show up. But even with all that, we are beating broad benchmark.

So, when I provide my performance, both from a peer group perspective and from a benchmark perspective, those are not carved out ESG peer groups or ESG benchmarks. Those are broad benchmarks. So, in the U.S., we run a Calvert Bond Fund, which is benchmarked to the U.S. Ag, it is – I think in Morningstar it is now into the core-plus category in the U.S.

So, it competes in the core-plus category even though there are 300 competitors who might not care about ESG. And it competes with U.S. Ag, which is the broader benchmark that we can show our performance with.

The point that I'm trying to make that you don't give up performance, you don't take extra risk by, applying E, S and G factors to your investing. So, this should be mainstream investing.

This should not be, oh, this is a niche part of my portfolio that I'm allocating to. You should look at ESG investors both from a perspective of whether each company and each stock and each bond can be explained from an ESG perspective, as well as are you beating broad benchmarks or not. So, I think that dual goal of doing it responsibly, but then beating broad benchmarks is what we strive for.

Freeman: Vishal, thanks very much for your time today.

Khanduja: Thank you. Thank you for taking the time.

Freeman: I'm Glenn Freeman for Morningstar. And thanks for watching.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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