Could negative screening carry hidden risk?

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While the use of so-called negative screening may protect investors from exposure to some harmful assets, fixed income managers should also consider more sophisticated ways to invest responsibly in credit markets, says Insight portfolio manager Damien Hill.

While interest in responsible investment continues to gather pace, portfolio managers are adopting a growing variety of techniques to address environmental, social and governance (ESG) considerations within their portfolios.

Negative screening – a technique devised to identify companies that score poorly on ESG factors and ultimately exclude them from portfolios – has proved a popular tool for some. Yet Insight Investment portfolio manager Damien Hill believes that while negative screening has its uses, it can also carry risks when used in isolation.

He believes investors should consider a broader approach, combining other responsible investment techniques and strategies – such as conducting detailed analysis of companies and targeting materially positive impact allocations via green bonds and other impact-based investment instruments.

Hill points out that, in some cases, negative screening can leave investors overly concentrated in sector allocations that may be riskier than they seem.

Commenting on the specific pros and cons of negative screening in credit markets, Hill says: “If investors screen out large numbers of whole sectors for ethical reasons this can expose them to more concentrated sector allocations. This means that if they are left with large allocations to, say, the banking or insurance sectors they may be exposed to more risk than they think. While the banking sector may seem a benign place to invest, it has not been without its governance red flags over the years,” he says.

Rather than just adopting negative screening we believe there is a greater need for investors to engage with underlying bond issuers and build detailed analysis and increased scrutiny of companies they invest in across all sectors. When looking at banking sector investors need to pay particular attention to the carbon footprint of issuers’ lending books,” he adds.

Risk factors

Commenting on the growing importance of responsible investment across credit markets and some investor concerns it might impact fund performance, Hill adds: “Consideration of the governance risk and broader ESG and environmental and social risks is increasingly important in today’s market.

If you get the measurement of these risks right it can make a material difference to portfolio performance and risk mitigation. Responsible investment need not be detrimental to returns, though management of ESG risk remains an evolutionary process and always requires a careful approach.

Responsible investment related funds have seen exponential growth in recent months and fixed income markets are increasingly moving to embrace this approach through ‘green’ investment and other means.

In just one move the Bank of England (BoE) last year announced plans to use £20bn of its corporate bond holdings to put more pressure on the companies it invests in to cut greenhouse gas emissions¹. Against this backdrop, Hill anticipates significant growth in sterling denominated impact bond issuance.

We do expect the pace of sterling denominated impact bond issuance to accelerate further and this has been a trend over the past few years as the UK plays catch up with the euro market. Growth in this market is clear to see. In early 2019 less than one per cent of the sterling investment grade market was made up of green and other impact bonds.

In early 2020 there was just over one per cent and now that figure is closer to three per cent. We think the recent announcement by the BoE to reorient its corporate bond holdings on greener companies will only add further fuel to this trend,” he says.

One area of potential future concern for Hill is a perceived supply and demand imbalance for green bonds as often these bonds can trade at lower yields than corresponding non-green bonds from the same issuer. In the current market, however, he believes this should pose little risk for investors.

By holding large quantities of some green bonds there is a risk of a ‘carry’ deficit on the investor’s portfolio. However, we think a marginally lower yield can be justified to some extent for these bonds, given we expect demand for these bonds to continue to outstrip supply for the foreseeable future.

In a weak credit market, we would expect these bonds to outperform, as a higher proportion of these bonds will tend to be held by long term strategic allocators rather than short-term investors,” he concludes.

¹Reuters. Bank of England aims for greener corporate bond portfolio. 21 May 2021.

GE605271 Exp: 31 March 2022

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