ESG Considerations for Fixed Income – Liability Driven Strategies

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of liability-driven fixed income strategies and the link to ESG investing. We begin by discussing some of the foundational concepts used by asset managers to manage liabilities using fixed income instruments. It is important to distinguish liability-driven investing from asset-liability management. Asset-liability management is a strategy that considers investor assets in relation to liabilities. Liability-driven investing is a type of asset-liability management that manages assets in relation to the characteristics of the liability. Liabilities can be characterized by the certainty of their amount and payout date. After providing an overview of liability-driven strategies, we then shift our discussion to why ESG matters for liability-driven investing.

Strategies for Managing a Single Liability

Investment managers tasked with managing a liability must consider the timing and value of cash flows associated with the liability. Liability immunization attempts to minimize variance in returns and fund the liability with a high degree of certainty. Immunization techniques include cash flow matching, duration matching, and contingent immunization. Immunization may be referred to as zero replication meaning the performance of the bond portfolio replicates a zero-coupon bond that provides for perfect immunization. The zero-coupon bond has a maturity that matches the liability and there is no reinvestment risk as the bond is held until maturity. The wrinkle in this approach is that such a bond often does not exist. In these cases, investment managers will often look to immunize a single liability using duration matching. Duration matching requires that:

1. the present value of the asset must be greater than or equal to the present value of the liability;
2. the Macaulay Duration of the liability must be equal to the Macaulay Duration of the assets;
3. the convexity of the portfolio should be as low as possible to minimize structural risks arising from shifts and twists in the yield curve; and
4. the portfolio must be continuously rebalanced to maintain the duration match over time.

This rebalancing can be accomplished by buying and selling bonds or using interest rate derivatives.

Strategies for Managing Multiple Liabilities

When an investment manager is looking to immunize a portfolio with multiple liabilities (compared to a single liability) the immunization process is slightly different. The manager has the option to immunize with a cash flow matching strategy where a portfolio of zero-coupon bonds may be used to match cash flows to the liability. If this is done, the liability could be removed from the balance sheet (a term referred to as accounting defeasance). More typically however, the manager will follow a duration matching strategy. Like liability management for a single liability, there are four requirements:

1. the present value of the asset must be greater than or equal to the present value of the liability;
2. the basis point value of the liability must be equal to the basis point value of the assets;
3. the convexity of the asset should be greater than the convexity of the liability, but these should be as close as possible; and
4. the portfolio must be continuously rebalanced to maintain the basis point value match over time.

Basis point value matching can be done using a derivatives overlay. A derivatives overlay is used to adjust the basis point value of the asset and hedge the duration gap. This can be achieved by buying or selling swaps and futures.

Liability-based Strategies Under Various Interest Rate Scenarios

Given the need of the portfolio manager to balance the basis point value of portfolio assets and liabilities, we now turn our attention to selected strategies to meet this objective. If a portfolio manager is looking to increase the duration of their portfolio, they can go long bond futures or fixed-rate swaps. Swaption collars or receiver swaptions can also be used to increase portfolio duration. The portfolio manager can also increase portfolio duration by using options (i.e. adding a call on a bond or a put on the option rate) or by using leverage (i.e. equivalent to borrowing at the short-term interest rate and buying a fixed rate bond). Why would a portfolio manager want to increase portfolio duration? The primary motivation is to position the portfolio in anticipation of changing interest rates. If interest rates are expected to rise, the manager will benefit if the hedging ratio is less than 100%. In this case, the portfolio would be structured so that the basis point value of the liability is greater than the basis point value of the assets. Rising interest rates will typically reduce the value of the immunizing bond portfolio, so the manager will want to reduce its position size in that asset.

Risk of Managing Liabilities

There are several risks associated with managing a portfolio against a liability structure. The amount of hedging is calculated base on an assumed duration and convexity. If the assumptions about duration and convexity are not correct, this will create problems for liability management. Duration only provides protection to parallel shifts in the yield curve, but the yield curve can undergo structural changes (twists and shifts) where duration does not provide protection. There is also risk that complex liabilities, like defined benefit pension plans, cannot be modelled accurately. If the liability cannot be modelled, immunization will be difficult. Measurement error is another challenge associated with liability management. When a manager looks to alter portfolio duration using bond futures, the basis point value calculations are based on a bond that is cheapest-to-deliver at the time of expiration. The bond that is cheapest-to-deliver at any given time is subject to change and this can create difficulties in matching asset and liability durations. Spread risk arises when asset yields and liability discounts change on corporate securities. This risk can occur at any time as the economy progresses through the credit cycle. When over-the-counter derivatives are used in liability matching, counterparty and credit risk can become and issue, although, this can be mitigated by requiring counterparties to post collateralization. If the manager is on the other side of that trade, there could be a cash short-fall risk if the manager is required to post margin for derivatives purchased.

ESG Consideration for Liability-driven Investing

Having provided an overview of strategies for liability management, implications for various interest rate scenarios, and risk considerations, we now turn our attention to ESG considerations and why they are important for liability management. ESG indicators can be important for helping the investment manager to understand the future. This allows for the construction of a more sustainable portfolio. There are two ways that ESG factors can be used in investment decision-making:

1. by expanding the set of factors that can be used to predict returns; and
2. by increasing the robustness of a portfolio through enhanced risk management diligence ^[2].

ESG matters in the credit research process because these factors can be used to better understand and avoid potential credit downgrades or defaults. In liability-driven investing, given the long-term nature of many contracts that asset managers enter in to, ESG considerations are even more important. The most relevant factors are related to governance issues and include strength of the business model and risk management processes.

When a liability-driven investing mandate references ESG considerations, this is typically done through assessment of ESG-related criteria as part of the counterparty review or through governance, where long-term structural issues are addressed ^[3]. Factors that are considered in counterparty review include quantitative factors such as leverage, profitability, asset quality, and liquidity. Qualitative factors are also considered, and these can include ESG factors, market signals, diversification, and geopolitics. Governance and sustainability issues could impact the value of investments, so a long-term perspective is important. This could include assessment of things like regulatory change and minimizing counterparty risk – tactical issues for an investment manager looking to immunize a liability structure. Certainly, as the market continues to evolve, ESG factors will continue to play an important roles in liability-driven investing as it does in other fixed income investment management strategies.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.aberdeenstandard.com/en/uk/institutional/insights-thinking-aloud/article-page/the-role-of-esg-in-an-endgame-portfolio
3. https://www.lgimblog.com/categories/esg-and-long-term-themes/esg-in-ldi-and-derivatives/

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