Corporate debt and responsible investment

Corporate debt
and responsibleinvestment
January 2024

Corporate debt and responsible investment guidelines

Corporate debt andresponsible investment guidelines
The relevance of fixed income instruments, as well as other asset classes as a component ofsustainable investment, was identified in the UN Principles for Responsible Investment, originallylaunched in 2006. While much of the focus in responsible investment to date has been on equities,
increasing attention is being paid to other asset classes — in particular corporate debt.

Shareholders play a particular stewardship role by exercising
their ownership rights, including voting, to urge companies to
pay appropriate attention to the management of material ESG
risks. However, it is also the case that a firm’s creditors andbondholders are key financial stakeholders and, thus, share
a common interest with shareholders for the company tomanage ESG risks and contribute to strong long-term
financial performance.

Fiduciary responsibility for fixed-income as well as
equity assets
We engage with portfolio companies, as both a shareholder andcreditor, to encourage companies to pursue policies and practices
that enhance the sustainability of all corporate asset classes.
This interest has been motivated in part by greater recognition
from pension funds and their trustees that fiduciary responsibility
to address long-term ESG risks is relevant for bond investments
as well as for equities. This is particularly the case for clients
whose portfolio de-risking has resulted in the shifting of asset
allocation from equities into bonds.

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Why ESG issues are relevant to bondholders
In most companies and in most sectors, debt forms a core partof a company’s long-term permanent capital. This is particularly
true in the case of financial institutions and many utilities. In thiscontext, a company’s providers of debt capital share a similar
exposure to long-term material ESG risks as its shareholders.
However, while creditors are theoretically more protected fromfinancial problems than shareholders, both are affected by acompany’s ability to generate long-term operating profits andcash flows to allow for debt service, dividend payments andcapital appreciation. Financial, operational, and reputational risks
relating to ESG factors can affect a company’s ability to generate
stable cash flows to honor its financial obligations.
Indeed, there is a clear convergence among corporate creditorsand shareholders on many issues affecting a company’s
management of risks relating to ESG performance.
It is also worth noting that compared to equity investors,
creditors have relatively more limited upside potential ininvestment returns, as income is fixed, not variable. Thiscan cause creditors to be relatively risk-averse and focus oncompanies avoiding the downside − namely the possibility thattheir financial contracts will not be honored. In this regard, robust
identification and management of material ESG risks is a form ofenterprise risk management that serves to promote the long-term
stability of the company and ultimately protect creditor interests,
including the value, performance, and liquidity of fixed income
portfolios.

Corporate debt and responsible investment guidelines

What we expect from bond issuers
As an investor in bonds and other forms of corporate debt
instruments, we expect debt issuers to conduct their businessin a way that protects creditor interests. This includes showing
proper respect for shareholder interests, as a sustainable
company must maintain access to both equity and debt capital.
Our fixed income engagement focuses on those aspects ofgovernance that reflect a company’s overall risk profile, a key
concern for creditors. These include:
1. Clarity on financial policy. Companies should be transparent
to both creditors and shareholders regarding their financial
policies. Particularly with regard to creditors, a company’sreporting should include a policy statement on the use ofdebt and the level of credit quality the company wishes toutilize. It is appropriate for a company to pursue a higher-risk
strategy involving debt finance. This strategy, however, should
be clear to both existing and prospective debt investors sothat it can be reflected both in pricing and the fundamental
investment decision.

3. B oard effectiveness. Bondholders want boards to be awareof creditors’ interests and to demonstrate appropriate regard
for maintaining and building the long-term financial health ofthe company. Creditors also want strong and effective boards
that are able to oversee company management and provide
appropriate checks and balances to prevent abuse.
4. A udit process. A particular focus of creditors is a robust
audit process, including an independent audit, appropriate
accounting policies and high standards of transparency anddisclosure in financial reporting.
5. C ompensation. Performance metrics reflecting a company’s
own financial strength and stability can (and should) be
reflected in company incentive structures. Such metrics may
include relevant ESG metrics and feature as a componentof a balanced scorecard guiding annual bonus awards.

2. Risk management. The company’s risk management and risk
governance are fundamental concerns for both creditors andshareholders. This not only relates to basic internal controls,
but also to risk management in the broadest enterprise-wide
context − incorporating financial, operational and reputational
factors. In this context, ESG and ethical factors can present
significant risks to the company and its investors.

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Important Information: This communication is valid at the date of publication and may be subject to change without notice.

WF546149 (12/23)