• Investment Management

Bondholders to Companies: Let’s Talk About Climate Change

As the cost of climate change-related natural catastrophes grows, for the first time bondholders are pressing their portfolio companies about risks and other environmental, social and governance topics.

In the world of sustainable investing, a new trend is forming among bondholders: Until recently, stockholders with voting rights were the investors empowered to engage their portfolio companies about environmental, social and governance (ESG) risks—and to advocate for change. Now, creditors are also taking up the gauntlet to guide corporations in which they invest to move in more responsible directions.

Managers of bond portfolios, heeding their socially conscious investors—pensions, endowments and non-profits—are pressing companies on sustainability issues, notably climate change topics ranging from risk modeling to carbon emissions exposure. But one industry where climate change risks may be overlooked is the insurance sector.

Historically, equity investors have led direct engagement about ESG risks and opportunities. But as creditors, we also have a duty to guide companies.
Joseph Mehlman Head of U.S. Credit, Morgan Stanley Investment Management’s Global Fixed Income Team

Since 1980, the number of global natural disasters, including storms, hurricanes, flooding, forest fires, unusually high air temperature and drought has more than tripled, with overall and insured losses steadily rising. Between 2016 and 2018 alone, climate change-related weather events caused more than $630 billion in economic damage worldwide.1

In 2019, Morgan Stanley Investment Management’s Global Fixed Income team, which manages $88 billion in assets, began proactively asking corporations in which they’re bondholders about ESG topics, and at the fore are conversations with property and casualty insurers about their management of climate change risks. The financial implications make corporate disclosures and proper investment analysis essential, according to Joseph Mehlman, head of U.S. Credit on Morgan Stanley Investment Management’s Global Fixed Income team.

“Historically, equity investors have led direct engagement with companies about ESG risks and opportunities because they have leverage—they can advocate for change,” Mehlman says. “But as creditors, we also have a duty to guide companies, and we’ve happily adopted it because it helps us be better investors.”

Climate Change Risk and Bond Yields

Pressing for financial disclosures related to climate change is a nascent practice that creditors are attempting to standardize. Some corporations are voluntarily aligning with the Task Force on Climate-Related Financial Disclosures, a global consortium that provides recommendations about how to include climate change data around governance, strategy, risk management and targets in annual filings.

If the disclosures aren’t there, we ask ourselves: Are we being paid enough to take the risk?
Kenneth Mayeri Credit Research Analyst, Morgan Stanley Investment Management's Global Fixed Income Team

The potential liability of investing in insurance companies with limited reporting on climate change has creditors weighing yields of property and casualty reinsurers’ debt against less exposed primary insurance underwriters, says Kenneth Mayeri, a credit research analyst on the Global Fixed Income team who covers the insurance industry.

At similar ratings and maturities, reinsurer corporate bonds can offer 50-100 basis points of additional spread compared to their primary insurer counterparts. Reinsurers that disclose quantifiable information about their natural catastrophe exposure, such as the “probable maximum loss” metric, provide an extra layer of transparency to investors, even if such metrics are not perfectly comparable across issuers.

“If the disclosures aren’t there, we ask ourselves: Are we being paid enough to take the risk?” Mayeri says. “We might avoid an investment until we get those disclosures.”

Engaging with Companies on ESG Issues

Across its strategies and more than $500 billion in assets2, Morgan Stanley Investment Management encourages investment analysts to lead the charge on direct engagement. Outsourcing the work to sustainability experts may isolate issues as environmental or social problems, when they also have financial repercussions and should be integrated in fundamental analysis.

The Fixed Income team focuses on being active owners and implementing processes that incorporate ESG issues into investment decisions. Targeted engagement practices create healthy dynamics between investors and companies that increase transparency, diffuse new ESG knowledge and build political capital to effect change, says Victoria Li, a credit research analyst who covers the health care industry.

“For starters, analysts can identify leaders and laggards by sector in terms of disclosures and governance practices,” Li says.  

The team aims to encourage bad actors to change, whether that means asking utility companies whether they would consider issuing green bonds to fund renewable energy projects, or engaging health care manufacturers about drug pricing responsibilities and accessibility. While not all conversations lead to portfolio actions, some have swayed the team to exit holdings.

To help refine its process, fixed income analysts are collaborating with counterparts in different asset classes within Morgan Stanley Investment Management to share knowledge on company engagement and move the needle on sustainability.

“We don’t need to be shy about saying this is new for us, as bondholders,” Mehlman says. “We’ll only get better and more sophisticated over time.”