Fixed Income ESG Survey Results

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Ursula Haynes
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1 Fixed Income ESG Survey Results Executive Summary Russell Investments Fixed Income Manager Research team has conducted a second annual survey of 109 fixed income managers to assess their attitudes to Responsible Investment and how they have integrated Environmental, Social and Governance (ESG) issues into their investment processes. We conducted a similar survey in 2015 and have expanded the questionnaire content and fixed income participants for This year s survey consisted of 20 questions with 13 sub-questions addressing the respondents attitudes toward ESG and its importance in their decision making processes. We were then able to compare the trends and observations from this year to the previous year. From the survey results, we observed an increasing level of ESG awareness and a widespread willingness to incorporate ESG factors into one s investment process. Interestingly we observed varying degrees and manners of how way fixed income managers integrate ESG factors into investment practices. In the previous year s survey results, we observed that a number of respondents appeared to understand that specific term ESG or Responsible Investing primarily in terms of their clients ethical value judgements, rather than in terms of investment fundamentals. However from this time around, we saw an increasing number of respondents claiming ESG considerations have direct impacts to investment fundamentals. That being said, academic research to support the investment fundamental argument was lacking. We found many fixed income managers subscribe to external vendor for specific ESG data. The leading investment practice for the ESG factor integration appears to be the one which utilizes the third-party vender ESG data with additional inhouse qualitative assessment overlay. A growing number of fixed income managers are branding themselves as an ESG friendly organization but we have observed that there often is a wide gap in what the survey respondents claim they do regarding ESG integration and what is happening from actual discussions with key investment professionals base during our manager research due diligence. Overall, we observed that ESG factor consideration appears to be not as a dominant driver in investment decision but rather as a supplemental information at best as a part of credit analysis. Introduction Environmental, Social and Governance (ESG) factors are increasing in popularity, which is not surprising. ESG factor considerations could offer investors the opportunity to make positive social impacts. Russell Investments has observed the ESG trend, which started among equity investors, expanding into fixed income investors in more recent years. To better understand how fixed income managers are integrating ESG factors into their investment processes, we have started to conduct an ESG survey among fixed income managers globally and this is the second annual survey. This paper shares the results of the second annual survey, which includes the level of ESG factor integration among fixed income managers, how the ESG engagement level has evolved from the previous year, what led those fixed income managers to incorporate ESG factors, and how ESG factors are integrated. We also gauge the ESG effort level, in terms of dedicated resources and fixed income product offerings in the topic. In addition to reporting on active manager information, we share how Russell Investments integrates ESG considerations into manager research and how we use the ESG survey to form our assessment of ESG integration for fixed income manager evaluation.

Survey population We invited 189 fixed income asset managers from around the globe to participate in the survey and 109 responded within the timeline requested.

2 Survey population We invited 189 fixed income asset managers from around the globe to participate in the survey and 109 responded within the timeline requested. The fixed income strategy offerings included in the survey were Global Bond, Global Credit, U.S. Core Plus, U.S. Core, U.S. High Yield, U.S. Bank Loan, Emerging Market Debt (local and hard currency), European Bond, U.K. Bond, U.S. Municipal, Canadian Bond, Japanese Bond, and Australian Bond. Respondents are headquartered as follows: 52% in the U.S., 27% in the European region, and 14% in Canada. In terms of asset base of the survey population, 53% of the respondents had firmwide assets under management of greater than USD 100 billion, 10% between USD 50 billion to USD 100 billion, and the remaining 37% less than USD 50 billion. We highly appreciate their participation and valuable time. ESG factor integration There is increasing interest in ESG issues among fixed income managers and a strong desire to blend one s branding to the topic. As a way to measure such trends, we asked the participants about their investment policy and process. We found that 68% of the participants responded have a responsible investment policy that covers how ESG considerations are integrated into their investment process (Exhibit 1). This is a notable jump from 49% saying yes to the same question last year. When asked about the timing of the firms implementing explicit ESG considerations, the majority of them have started to do so within the last four years. The findings suggest that interest in ESG issues among the fixed income managers has increased in recent years. Exhibit 1: Evidence of increasing ESG integration among fixed income managers Q: Does your firm have a Responsible Investment Policy that covers how ESG considerations are integrated into the investment process? From this question, we observed that European managers are further ahead of the U.S.-based fixed income managers in incorporating ESG considerations. Among the respondents, 92% of the European-based managers has a responsible investment policy regarding ESG factors, whereas only 58% of U.S.-based respondents have a similar policy. We noticed that boutique U.S.-based high yield managers are least likely to have explicit ESG considerations in their investment processes, even though asset size was not otherwise material. Among the respondents specified, 67% of the managers said they started to incorporate the ESG factors in the fixed income team in the last four years, a material jump in the last 18 months. ESG awareness among fixed income managers has certainly increased. In particular, we observed a widespread willingness to participate in the United Nations Principles for Responsible Investing (UNPRI). We noted that 76% of the respondents are UNPRI signatories, compared to 52% from the previous survey result. The participation expansion is shown in the exhibit 2. Year Managers Signed UNPRI Data: YTD 2016 as of April 2016 Why consider ESG factors When asked about the drivers of the ESG considerations and whether they have conducted specific capital market research for how ESG factors might have impacted in the investment results, only 15% cited some ESG related capital market research in the fixed income market. Only a handful of studies done assessed how ESG factor considerations impacted investment outcomes. Furthermore, we saw some results showing how ESG considerations have outperformed non-esg considered fixed income strategy over the assessed period, whereas others saw no significant underperformance or outperformance of ESG factor portfolios. Many respondents did not provide evidence that ESG considerations influence performance but stated how companies or countries who care about societal outcomes through environmental, social and governance factors could theoretically lead to improving credit hence producing positive economic values. While the evidence appears to be inconclusive, we should insert our view that we recognize the challenges in assessing the impact of ESG factors on security prices, given the impact of many ESG factors may show up episodically often observed through negative events.

3 That being said, we should also recognize that there is little evidence that targeting ESG factors enhance performance, as there is minimal supporting work in this area in the fixed income market. It is less controversial among managers that including ESG factors in their investment processes should provide a more comprehensive picture of the company or country risk. How ESG factors are integrated We observed a significant difference in the way the respondents integrate ESG factors into one s investment process. Some respondents have a more formal policy than others. Many have explicit ESG scores for companies or countries in which they invest. In attempt to obtain greater insights, we broke this topic into several questions. First, we assessed the methodology of the ESG factor considerations by ascertaining their data sources. Second we assessed the qualitative side of their program for example, we asked about screening policies and informal judgmental calls. Of the respondents who replied Yes to having ESG scores for companies or countries in which they invest, we ve asked the source of the database. We found the following: 15% of the respondents who claimed to have ESG scores said such scores are qualitative and soft inputs their investment team provides internally without using external vendors. 52% of the respondents utilize third-party vendors exclusively to obtain ESG scores. The remaining 35% of the respondents utilize external vendors for ESG scores but also overlay in-house ESG analysis to come up with overall ESG scores. The most popular external ESG vendors among fixed income managers are MSCI ESG Research and Sustainalytics. Among those respondents who subscribe to both vendors, many cited how MSCI ESG Research and Sustainalytics are complementary to each other. It appears that the leading ESG practices among the fixed income managers are those which invest in external ESG vendors that are then analyzed further internally to establish overall ESG scores for companies or countries. To gauge the meaning of ESG integration to one s investment process, we asked if ESG factors have ever been the dominant criteria in their investment decisions. 44% of the respondents had claimed to be overridden an otherwise attractive investment opportunities. We then further asked them to provide comments on what drove such decisions. The responses were unclear, to say the least. We categorized those responses into screen base and judgmental calls. Among the respondents that said Yes to having overridden investment decisions of otherwise attractive opportunities, 25% said the decisions were made because of ESG filters or screens established for specific clients. Rather than avoiding specific industries or sectors all together, some respondents stated how they select specific bonds within the sector. Some respondents stated they don t invest in bonds when they feel that ESG issues are deemed to have immediate material impacts and if a business is too vulnerable to regulatory or legislative risk affecting its ability to generate cash flows. ESG factors encompass a broad range of topics, such as climate change, sustainability, human capital employee health and safety, corporate governance, and so on. We asked which factors are considered the most important in one s investment decisions, and the majority of the respondents stated Governance. Other respondents stated that each ESG factor has an impact over the longerterm, hence they are equally important. Others stated Governance often plays an explicit role in assessing fundamentals of corporations, whereas the Environmental and Social factors are often more impactful to non-financial considerations. We have observed that some respondents cited having an ESG-integrated process, because they incorporate Governance into their investment processes. In other words, the Governance considerations were already a subset of fundamental investment analysis before they labeled them as ESG. Perhaps it might be more differentiating for fixed income managers if they put greater emphasis on the Environmental or Social factors, as such actions are additional ESG considerations and highlight greater commitments from managers. Dedicated resources in ESG efforts When asked about ESG resources, 56% of the respondents claimed to have dedicated ESG staff. Some managers took this question with a qualitative interpretation of dedicated as being someone spending more than 50% of their time on ESG related responsibilities. The nature of such ESG specialist roles varies by organization. At some managers, ESG resources are a part of their Corporate Governance and/or Sustainable and Responsible Investing (SRI) team. For some managers, the ESG team is more of a working group, while others have ESG integrated within the credit research team. Responsible Investing product offerings In order to gauge the ESG product availability in the marketplace, we asked if bond managers have offered any mandates for clients with specific ESG guidelines. We found 57% of the respondents claimed to offer or have offered specific ESG mandates. With regards to the nature of ESG considerations in such mandates, most of them apply

4 negative screens on some sectors or companies, such as any companies involved in manufacturing and sale of tobacco products, sale of alcoholic products or gambling activities. A number of respondents highlighted the importance of customization to tailor to an individual client s needs. While the screen-based approach has been dominant in fixed income ESG product offerings, some respondents shared their increasing discussions with clients for a positive integration approach where clients are interested in investing companies that have high ESG characteristics, as opposed to negative screen based investing. Green bond offerings Green bond product offerings have been very limited, but we have noted an uptick in such product offerings since Most respondents commented on the narrow investment opportunity set in the green bond market, as compared with traditional bond market. As a reference point, Barclays MSCI Global Green Bond Index consists of 129 issues with $88 billion market value, compared with 17,560 issues and a $48 trillion market value for the Barclays Global Aggregate Index, as of September 30, Some respondents recommended green bond mandates which allow investing in traditional corporate bonds a.k.a. non-green bond in a green bond strategy in order to construct a diversified portfolio. A few respondents shared the desire to support clients transition to a low-carbon economy and green bonds being a key tool for energy efficiency, renewable energy, and other related to climate adaptations. How Russell Investments integrate ESG considerations in manager research for bond managers Russell Investments employs a ranking system in its manager research process that incorporates factors that we believe impact the manager s ability to generate excess returns for our clients, both on an absolute basis and relative to peers. We have an ESG rank (scale of 1 to 5, with 5 being the highest) formally incorporated in our manager evaluation process. For the fixed income managers, we are leveraging our findings from this fixed income ESG survey into our manager evaluation process. From the ESG survey results, we have formulated an overall ESG score to each fixed income manager. Specifically, we have segregated each of the survey questions into four categories: Policy, Process, Offering, and Awareness. Each question gets assigned a score of 1 to 5, with 5 being the highest. We have applied a weighted average of 40% in Policy, 40% in Process, 10% in Offering, and 10% in Awareness categories to come up with an overall ESG score of 0.0 to 5.0 for each fixed income manager. This ESG score coming out of the survey is considered a quantitative score, based on our judgement, from the survey responses. It is important to note that we then apply qualitative assessment which comes from our manager research process. Our observations of the quantitative ESG scores from this survey may differ from our qualitative assessment formed from direct discussions with key investment professionals for specific fixed income strategies. There is often a wide gap in what the survey respondents claim they do regarding ESG integration, and what is actually happening. For instance, there have been several cases where certain bond managers scored highly in our quantitative ESG assessments, but scored poorly in the qualitative assessments. In other words, there are disconnects to what some bond managers say they do versus what s really happening in their ESG integration. Perhaps these disconnects come from corporate level communications which have not been funneled through broadly within the organizations. That being said, we do also see some bond managers treating ESG risk as an economical risk that can harm a bond issuer s enterprise value and credit quality, hence ESG risk assessments are embedded in their investment processes broadly. At Russell Investments, our aim is to reference the quantitative ESG scores from this survey and overlay with our qualitative assessment to form our overall view of how bonds managers integrate ESG factors in their investment processes. Summary and Conclusions Russell Investments Fixed Income Manager Survey 2016 found a high level of ESG awareness and increasing ESG factor integration among the respondent managers. A growing number of fixed income managers are branding themselves as an ESG friendly organization and we observed a widespread willingness to participate in UNPRI in recent years. ESG integration is more common among Europeanbased fixed income managers than U.S.-based respondents. The rationale of ESG factor integration appears to be driven by (a) the conception that ESG factor integration, as a part of credit analysis, should provide a more comprehensive picture of company s health and long-term sustainability, or (b) to satisfy moral value judgements, as the evidence of ESG factor integration contributing to positive investment outcomes seems inconclusive. We observed a wide range of methodologies in the way the respondents integrate ESG factors into one s investment process. We found many fixed income managers subscribe to external vendors for specific ESG data. The leading practice for the ESG factor integration appears to be the one which utilize the third-party vender ESG data with additional inhouse qualitative assessment overlays. To gauge the meaning of ESG integration to one s investment process, we asked if ESG factors have ever been the dominant criteria in their investment decisions. Less than half of the respondents had claimed to be overridden an otherwise attractive investment opportunities. We further found that some of such overridden occasions were based on a negative screening filter, such as avoiding certain sector or industry. That being said, some respondents stated they don t invest in bonds when they felt

ESG issues were deemed to have immediate material impacts and if a business is too vulnerable to regulatory or legislative risk affecting its ability to generate cash flows.

5 ESG issues were deemed to have immediate material impacts and if a business is too vulnerable to regulatory or legislative risk affecting its ability to generate cash flows. Overall, we observed that ESG factor consideration appears to be not as a dominant driver in investment decision making but rather as supplemental information as a part of credit analysis. Russell Investments integrates ESG considerations in manager research, and this ESG survey helped form our assessment of managers ESG integrations as a part of fixed income manager evaluation. From this ESG survey results, we have formulated an overall ESG score to each fixed income manager as quantitative assessment for ESG integration evaluation. We then apply qualitative assessment which derives from our direct discussions with individual manager managers as a part of our due diligence in our manager research process. What we found is that there often is a wide gap in what the survey respondents claim they do regarding ESG integration and what is actually happening. We should also note that there are some managers who treat ESG factors as an economical risk hence ESG factors are embedded deeply in their investment process broadly. At Russell Investments, our aim is to reference the quantitative ESG scores from this survey and overlay with our qualitative assessment to form our overall view of how bonds managers integrate ESG factors in their investment processes. We believe the results of this survey point to a market place that is reacting to client driven demand. The lack of common practices in ESG and the fact that there are frequently disconnects between policy and action may indicate that the industry is struggling to embed these processes and this vision satisfactorily. Contact us to learn more. Yoshie Phillips Senior Research Analyst Global Fixed Research YPhillips@russellinvestments.com Reference: Russell Investments publications Millen (2015) Russell Investments Bond Manager ESG Survey 2015 Forrest, Kuharic, Trecker (2016) Responsible Investment Beliefs and Capabilities FOR PROFESSIONAL CLIENTS ONLY This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell Investment product or use any Russell Investment services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation. Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Issued by Russell Investments Implementation Services Limited Company No Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS. First used: January 2017 Compliance Code

Image: The Caribbean Sea and Curacao RESPONSIBLE INVESTING ACTIVELY DESIGNING SOLUTIONS FOR THE FUTURE

Image: The Caribbean Sea and Curacao RESPONSIBLE INVESTING ACTIVELY DESIGNING SOLUTIONS FOR THE FUTURE OUR APPROACH NOT ALL RESPONSIBLE INVESTMENT SOLUTIONS ARE CREATED EQUAL Different organisations define