The Markets February 22, 2018

Institutional ESG Investing Can Bring Tough Reporting Questions

Highlights from a new Natixis survey suggest reporting challenges continue to rank as top hurdle for institutions implementing ESG programs; this includes the concern that public companies may be “greenwashing” reported data to enhance their public image.

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A new cut of data shared by Natixis Investment Managers is based on a broad survey of 500 institutional investors, including managers of corporate and public pension funds, foundations, endowments, insurance funds and sovereign wealth funds.

Among other findings, the survey results show these large-scale investors are embracing greater use of environmental, social and governance (ESG) investing programs—wherein the decision whether to invest in a given company or security directly weighs factors such as upstream or downstream environmental waste, resource scarcity, the present and future impact of global warming, the embrace of corporate best practices, and many other potential elements which advocates say directly impact the long-term performance of companies.

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The Natixis research shows 45% of institutional investors feel it is difficult to measure and understand financial versus non-financial performance considerations when establishing ESG programs. Some of their concern may be based on the criticism received by CalPERS and the New York City pension funds following fairly enthusiastic ESG implementation and fossil fuel divestment efforts. However, the Department of Labor (DOL) and other regulators and resources have offered extensive guidance on the topic as it pertains to retirement plans, it should be noted.

Shared by fewer investors but perhaps even more concerning is the fear that publicly owned companies may be “greenwashing” reported data to enhance their image from the ESG investing perspective, cited by 37% in the survey pool. This is the same number that cited concern about a general lack of transparency and standardization by companies when it comes to reporting ESG-related information for the purposes of securities disclosures.

The research further shows slightly more than a quarter feel concerned about a lack of third-party-reported data—almost exactly the same as the number who are concerned about how ESG trends “may not play out in the long-term.” Important to note, the firm says, in a 2016 edition of a similar survey, 42% of institutions cited difficulty measuring performance as the biggest challenge of ESG investing. So it seems those who favor greater use of ESG are making some slow progress in winning over the world’s largest public and private investors.

Among those already embracing ESG themes, Natixis finds institutions describe their approach to ESG investing as follows: Negative/exclusionary screening (36%); full ESG integration (26%); impact/activist investing (21%); thematic investing (14%); we do not incorporate ESG factors (40%).

The full survey results are here.

The Markets February 21, 2018

LPL Researchers Perspectives on Managing Interest Rate Risks

According to the researchers, sector diversification and yield curve positioning can help investors during rising-rate periods.

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As 2017 ended, fixed income investors were searching for income, after several years of 10-year Treasuries yielding less than 2.5%, according to John Lynch, chief Investment strategist, LPL Financial, and Colin Allen, assistant vice president, LPL Financial.

In an LPL research report, they note that when 2018 began, this changed quickly as tax reform and signs of inflationary pressures pushed market interest rates higher. The 10-year Treasury yield rose 0.87%, from a starting yield of 2.04% on September 7, 2017, to 2.91% on February 15, 2018. Investors have grown concerned that improving economic data and rising inflationary pressures may cause the Federal Reserve (Fed) to raise interest rates in 2018 at a more aggressive pace than originally anticipated. Given this backdrop, investors are naturally reassessing their interest rate risk.

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The researchers expect yields to grind gradually higher during the year, but not in a straight line. As such, they continue to recommend portfolio positioning with a duration (a measure of interest rate sensitivity) lower than the Bloomberg Barclays U.S. Aggregate Index, along with additional diversification across sectors, maturities, and credit ratings (for suitable investors), which may potentially help mitigate the impact of rising interest rates on investors’ portfolios.

A sector comparison of broad market returns can be can be used to determine relative outperformance or underperformance against the Bloomberg Barclays Aggregate. The data shows the difference between credit risk and interest rate risk is a meaningful one of which investors should be keenly aware, according to the research article. U.S. Treasuries have the least credit risk, as they are backed by the full faith and credit of the U.S. government. They carry elevated interest rate risk, however, as their price sensitivity to interest rate changes (duration) is higher than the broad Bloomberg Barclays Aggregate. This explains Treasuries’ underperformance in most of the rising rate periods. High-yield bonds, conversely, possess higher credit risk and lower interest rate risk. Generally, interest rates rise when economic growth and inflation pick up, a scenario that’s usually a good backdrop for economically sensitive portions of fixed income, like high yield. The additional yield cushion is also a buffer against higher interest rates that could push prices lower. Despite this, the researchers still believe lower-quality fixed income should be used at the margins of higher quality, for suitable investors.

According to the researchers, sector diversification and yield curve positioning can help investors during rising-rate periods. Investment-grade corporate bonds possess greater interest rate sensitivity than the broad high-quality market, because of their longer maturities. The researchers favor the intermediate portion of the yield curve, which boasts diversification benefits without the significant interest rate risk of long-term bonds. By either targeting intermediate-maturity corporate bonds directly, or using an active investment manager to position the portfolio opportunistically, investors can manage the headwinds of rising rates on investment-grade corporates.

The researchers add that high-quality mortgage-backed securities (MBS) have performed well in most rising interest rate environments.

Even though bond prices fall as interest rates rise, and interest rates have risen notably since the beginning of the year, investors should remain focused on their long-term objectives, the researchers warn. By focusing on total return rather than on short-term market price fluctuations, investors can avoid selling at inopportune moments due to emotion. Total return is the rate of return over time that is derived from interest income, plus gains or losses on the price of the bond. As interest rates rise, the cash flows of the bond will eventually be reinvested at higher prevailing interest rates. Over a longer horizon, the investor may chip away, or even overcome, price declines that occurred due to rising interest rates. “The takeaway is critical: it pays to remain patient,” the researchers wrote.

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