As active asset managers with a focus on long-term value creation and responsible stewardship, effective engagement is a critical part of our investment process and fiduciary obligations. Morgan Stanley Investment Management (MSIM) Fixed Income has developed a targeted and thematic engagement programme on environmental, social and governance (ESG) issues. Our approach is fully integrated into our research and investment processes to identify opportunities for improved risk management and alpha generation through constructive dialogues with issuers, while encouraging them to pursue positive sustainability outcomes.

The Growing Imperative for Fixed Income Engagement

Fixed income investors have an important role to play in building a constructive dialogue with issuers and supporting them in pursuing positive sustainability outcomes while enhancing ESG disclosure and price discovery of the proper cost of capital when accounting for ESG risks. While engagement and stewardship have historically been an equity investor remit, we believe fixed income investors are uniquely positioned to have a positive influence on issuers for a number of reasons:

• The responses to some of the world’s key sustainability challenges, such as climate change and access to basic services, are going to require large capital investments that are primarily financed via debt instruments,¹ including with sustainability labels.
• The vast majority of primary market financing is conducted in the debt market rather than in the equity market, giving fixed income investors a regular and direct interface with issuers seeking their capital.
• The magnitude of debt financing requirements increases in stressed scenarios (such as the recovery phase after the COVID-19 pandemic), increasing the frequency of such issuer/investor interactions and their importance in shaping issuer strategy.
• Fixed income portfolios typically hold a large number of securities and a range of issuers, in contrast to the more concentrated nature of holdings in active equities portfolios, giving investors a broad scope of engagement opportunities.
• Fixed income investors are uniquely positioned to engage with and influence issuers that do not have public equity outstanding, including Sovereigns, Supranationals/Agencies, many High Yield companies and state- owned enterprises.
   

MSIM’s Rationale for Fixed Income Engagement

Our Fixed Income engagement programme aims to achieve three main objectives:

1. Deepen our insight and understanding of the issuer and its sector;
2. Push for better sustainability outcomes; and, ultimately,
3. Capture alpha opportunities that may not be fully appreciated by the market.

Insights from the engagement process can therefore result in changes to our Credit Analysts’ assessment of the issuer. This may in turn lead to a decision to participate in a new issuance, increase

or reduce our existing holdings in outstanding bonds, or “watch-list” the issuer for our Sustainable Funds until more progress is made on the specific E, S or G issue of concern.

Finally, we strive to provide the same level of transparency that we expect of issuers. We therefore track and report our

engagements on a quarterly basis, including their outcomes—i.e. whether they affected our investment strategy through the Analyst’s recommendations or the Portfolio Manager’s investment decision.

The MSIM Fixed Income Approach to Engagement

At MSIM Fixed Income, we view engagement as an indispensable and powerful component of our ESG integration approach and to implement our sustainable investing strategies² (see Display 1). This is aligned with our 100% active management model and our duty as responsible stewards of capital.³

To this end, we have established an active engagement strategy that is based on three pillars (see Display 2) and is applied across fixed income asset classes. This structure is intended to:

• Help MSIM identify target companies for engagement based on material ESG considerations relative to their current stage of adoption of sustainability;
• Anchor the dialogue to a consistent set of thematic priorities that drive our key desired outcomes; and
• Implement engagement as part of our regular fixed income investment process, with Credit Analysts leading the dialogue with the support of the Fixed Income Sustainable Investing team.

1.  TARGETED ENGAGEMENT – INVESTING TO IMPROVE SUSTAINABILITY OUTCOMES AND RETURNS

We select issuers to prioritise in our engagement programme based on the materiality of the ESG risks or opportunities they present. We rely on our proprietary ESG scoring models and research capabilities to determine and monitor any “red flags” on controversies or violations of international norms,

and identify exposure to severe ESG risks. This risk mitigation-driven focus on ESG laggards is complemented by a strategic outlook on sectoral sustainability opportunities, where we engage with issuers that we believe have the potential to benefit from those positive tailwinds. Our goal is to identify those ESG improvers, whose progress might not yet be reflected in their public reporting and third-party ratings, as a potential source of alpha generation. Finally, we also engage in conversations with ESG leaders that already have advanced sustainability credentials, to encourage them to share best practices across their sectors, support the adoption of new disclosure standards, and promote innovative sustainable solutions.

We approach issuer engagement constructively and collaboratively. Depending on the impetus for dialogue, the MSIM Fixed Income team seeks

to set clear expectations from the engagement process. These can include the disclosure of specific data points, promoting the adoption of recognised ESG reporting standards, or suggesting alternative practices where we are concerned with a certain course of action taken by the issuer.

We understand that the various fixed income asset classes are at different stages of development of their sustainability practices and ESG disclosure, and we adapt our engagement approach and expectations accordingly (as presented in Display 3).

2. THEMATIC FOCUS MAPPED TO THE UNITED NATIONS SUSTAINABLE DEVELOPMENT GOALS (UN SDGS)

Our engagement priorities are based on salient ESG risks and opportunities at a sectoral level, reflecting our Credit Analysts’ sector specialisation and our broader approach to ESG analysis. We

have established a framework that maps these sector-level considerations to four “macro” environmental and social themes, presented in Display 4, which help us define the desired outcomes of our dialogues with issuers and report on progress.

As fixed income investors, we view governance as the strongest ESG driver of portfolio risk and return, and the pillar from which strong credibility is built across any sustainability-related topic. We therefore diligence corporate governance, transparency and accountability, and disclosure matters across all of our dialogues with issuers.

Our thematic framework informs not only engagement, but also the active security selection process in our fixed income strategies, and is part of our broader commitment, at MSIM, to support investments that positively contribute towards the UN SDGs.⁵

3. INTEGRATED PROCESS LED BY CREDIT ANALYSTS

ESG topics are included in all of our touchpoints with issuers’ management and during roadshows, based on the thesis that we can be more influential in our engagement by regularly following up with issuers on a focused agenda of salient points as opposed to conducting sporadic, diluted sessions on a broad range of sustainability topics.

For this reason, our fixed income engagement process is led by the Credit Research team based on an analytical, data-driven approach to evaluate ESG risk for the targeted issuers. Our Analysts have a deep understanding of the companies they cover and the engagement topics complement their comprehensive approach. The MSIM Fixed Income Sustainable Investing team contributes specific ESG expertise, ensures consistency across thematic engagements, and coordinates with the MSIM Global Stewardship team for equity-side insights.

In cases where we identify significant sustainability risks or egregious conducts, we may conduct joint engagement with multiple MSIM investment teams, to leverage our broader business influence and address our concerns and expectations in a coordinated manner.

Collaborative and Market-Level Engagement: Driving Best Practice and Standardised ESG Disclosure

In addition to our one-on-one engagement programme with issuers, MSIM Fixed Income also collaborates with external partners and stakeholders to promote the adoption of best practices and international standards for sustainability disclosure, as shown in Display 5.

Genuine Dialogue Means Both Sides Become Wiser

MSIM Fixed Income takes the view that the best form of issuer engagement is a process of dialogue, in which issuers are willing to consider alternative perspectives to help them evolve their approach to sustainability and investors are willing to change the assumptions and conclusions in their investment analysis.

We aim to maintain a regular dialogue with issuers where we deem it most material. Consequently, many of our engagements are ongoing over a multi- year time horizon. This approach takes into consideration the time lag required for issuers to endorse new policies and sustainability targets, measure ESG impact, and reflect this information in the following period’s public reporting.

As responsible long-term investors, our goals from engagement are to support improving behaviour, facilitate meaningful change, and to use the insights we glean to drive returns for the benefit of our clients.

¹ See “The Butterfly Effect & COVID-19: Six Implications for Sustainable Investing in an Interconnected World”, Morgan Stanley Investment Management (link).

² See Morgan Stanley Investment Management’s Sustainable Investing Policy (link).

³ See Morgan Stanley Investment Management’s Engagement and Stewardship Principles (link).

⁴ See “Assess, Engage, Perform: The Value of ESG Integration within High Yield”, Morgan Stanley Investment Management (link).

⁵ See Morgan Stanley’s 2020 Sustainability Report (link).

⁶ The PRI’s ESG in Credit Risk and Ratings Initiative aims to enhance the transparent and systematic integration of ESG factors in credit risk analysis (link). The third party websites are provided for informational purposes only. Morgan Stanley has not reviewed any of the content supplied, and does not guarantee any claims or assume any responsibility for the content provided by the sites.

⁷ Morgan Stanley is a member of the Advisory Council of the Green Bond Principles and Social Bond Principles Executive Committee of ICMA, and part of the Working Groups on Social Bonds, Sustainability-Linked Bonds, Impact Reporting, and Climate Transition Finance (link). The third party websites are provided for informational purposes only. Morgan Stanley has not reviewed any of the content supplied, and does not guarantee any claims or assume any responsibility for the content provided by the sites.

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. ESG Strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.