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A school of fish swimming in a coral reef.

We can all get along

Contributors
  • Mitch Reznick

    Head of Research & Sustainable Fixed Income, International

  • Hans-Christoph Hirt

    Head of EOS

For ESG engagements, bond and equity investors have common cause

Long-term bondholders and shareholders both have legitimate cause and a professional duty to engage on environmental, social and governance (ESG) issues. To challenge the long-running argument that investors in bonds and equities have diverging interests that preclude them from engaging with companies on the same concerns, we make two points.

First, the shared interests of long-term bond and shareholders in companies provide incentives to jointly engage companies—and generate positive outcomes by doing so.  Federated Hermes’ view is that the legitimacy to engage with companies on ESG issues as well as strategy, risk management and operational performance is based on the financial stake possessed by the bond or shareholder. Like shareholders, bondholders have a financial stake in the companies on whose balance sheets their debt resides, and the returns from both debt and equity instruments are ultimately linked to the performance of the underlying company. Also, in cases of insolvency, bondholders typically have a stronger claim on the value of a company, providing an added incentive to understand and help preserve its drivers of long-term performance. If companies want continued access to the debt markets on reasonable terms, they need to listen to what bondholders have to say – and the performance-enhancing influence of robust ESG risk management means that debt investors should engage on these matters.

While there may be divergence on specific issues, bond and shareholders broadly seek the same outcomes for companies in which they invest: stable, sustainable growth and value creation for the long term.

Second, the interests of bond and long-term shareholders are substantially aligned. While there may be divergence on specific issues, bond and shareholders broadly seek the same outcomes for companies in which they invest: stable, sustainable growth and value creation for the long term. For shareholders, growth creates value as cash is generated to pay dividends and retained earnings build a company’s capital base. As earnings grow and expectations of sustained earning growth continue, shares increase in value and returns to shareholders accrue. At the same time, the company’s credit profile will improve, resulting in tighter or more stable spreads.

The difference in the payoff profile of equities and bonds is sometimes cited as another reason that bondholders engage less on long-term factors, such as ESG issues. The thinking is that because a stock price can theoretically rise in perpetuity, shareholders focus on growth. Meanwhile, bondholders are supposedly less concerned about growth because their upside is capped by the nature of debt instruments, such as limitations on spread tightening, maturities and call options. But bondholders do seek corporate growth because rising enterprise value increases the difference between financial leverage and a company’s value, creating implied equity. This provides a buffer between the company’s full value and the nominal value of its debt, causing its credit risk to decline. One caveat is that any rise in enterprise value must be stable and sustainable. For example, a debt-driven increase in enterprise value can impair the sustainability of future growth as more and more cash is allocated to servicing debt rather than supporting the company’s operations.

How bondholders can engage companies for the benefit of all stakeholders

At Federated Hermes, our engagements focus on issues that are most material to a company’s ability to create long-term value. We begin by identifying potential engagement objectives and outcomes at the sector level, based on our top-down understanding of thematic risks. These are revisited at the company level to gauge their materiality and feasibility, together with our knowledge of how well the company appears to be managing the risks. Generally, we aim to engage at the most senior levels, such as board directors and executive management, because this can lead to the greatest impact on company activities. We measure and monitor engagements using a milestone system – developed by our stewardship services team – by assessing progress against four turning points:

  1. Raising the ESG concerns
  2. Acknowledgement (or not) by the company
  3. Credible plan set up by the company to address ESG concerns
  4. Objective achieved (or not) and implementation of the plan

In our experience, and based on numerous studies1, including several that the international business of Federated Hermes has conducted or participated in, there appears to be negligible risk of a conflict of interest between long-term shareholders and bondholders on ESG concerns.

Getting along for the good of all. In important areas – such as climate change, resource efficiency and workplace health, safety and equality – all financial stakeholders are aligned. That long-term equity and bondholders can have a united voice in encouraging companies to implement positive change on these fronts bodes well, as businesses that seek to future-proof their operations against sustainability risks are more likely to perform well, generate sustainable wealth and benefit a wide range of stakeholders.

1 See, for example: “ESG Shareholder Engagement and Downside Risk (Working Paper),” by Hoepner A., Oikonomou I., Sautner, Z., Starks, L.T., and X. Zhou, published in January 2018; “Active Ownership,” by Dimson, E., Karakas, O., and X. Li, published in 2015 by the Review of Financial Studies, 28(12), 3225-3268; “Activism on Corporate Social Responsibility,” by Barko, T., Cremers, M., and L. Renneboog, published in 2017 as an ECGI Working Paper No 509/2017; “How ESG Engagement Creates Value For Investors and Companies,” published in 2018 by the Principles for Responsible Investment; and “ESG’s Evolving Performance: First, Do No Harm,” by Renshaw, A. Ph.D., published in July 2018 by Axioma.

The value of equity securities will rise and fall. These fluctuations could be a sustained trend or a drastic movement.

Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.

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