Sustainability in Fixed Income

We continued to focus on strengthening our ESG integration frameworks for various fixed income subasset classes, including corporate debt, sovereign debt and US municipal subsovereign debt, among many others. Some examples of this work are described below.

Changing views on aerospace and defense
European defense has historically suffered because it has been grouped with tarnished sectors such as gambling and tobacco, given the consensus view of what constitutes harmful and socially unsustainable activities. In most cases, these concerns were merited, given weapons manufacturers’ close links to governments — including supplying dictators and rebels — along with their dependence on outdated environmental technology against a backdrop of weak governance and omnipresent bribery and corruption. As a result, aerospace and defense predictably ended up in an exclusion bucket for many investment managers as well as financial institutions across Europe.

The European SRI Study 2018 found that for EU investors, 63.6% of European Union investors excluded “controversial weapons” and 45.7% excluded “all weapons.” However, after the invasion of Ukraine, early indications highlight a renewed attitude on defense, with signs of a more accommodative backdrop and initiatives to realign the security and defense “strategic compass” by 2030. Now that multiple countries, particularly in Europe, have pledged to increase their defense and military spending, some investors are starting to rethink their exclusionary approach on the defense sector. 

Additionally, the aerospace and defense sector will continue to play an important role in protecting people and promoting prosperity — with certain long-term projects important in stimulating economic growth across many countries. The evolution of social arguments within sustainability communities has most recently led to European defense manufacturers becoming associated with promotion of the UN sustainability goal of “Peace, Justice and Strong Institutions” because they help defend the values of liberal democracies and provide an important deterrent in the effort to preserve peace and stability. However, transformation of governments will require many years (if not decades) to implement strategic resets on defense spending (if that is even possible).

For bondholders focused on financial materiality, sustainability cannot be considered an indicator of right or wrong — and binary EU social taxonomy inclusion or exclusion does not validate moral concerns or conclusions — therefore bottom-up assessment of issuers will remain essential in determining risk/reward for bond valuations.

Case study: European electronic systems and device manufacturer
As the Russian invasion of Ukraine gathered momentum in early April, one of our analysts reassessed our credit recommendations on a European electronic systems and device manufacturer for the defense sector alongside documenting a more nuanced longer-dated view on ESG within the sector. The company took steps to improve its credentials, especially given longstanding governance concerns over boardroom appointments, quantified objectives and longterm targets. Bonds performed well in 2022, with a backdrop of war supplemented by a deleveraging of balance sheet (via disposals) and an eventual credit rating upgrade.

The company has delivered on important ESG milestones and appointments, including the appointment of a new chief sustainability officer and two new board members focusing on corporate development and social responsibility along with the implementation of new anticorruption practices. We believe management will help mitigate governance deficiencies, which, combined with strategic clarity, will improve decision making, so the company is no longer a concern from a sustainability standpoint. Given the economic changes for defense companies and improvements from a sustainability standpoint, we think the company can potentially perform well over the mid- to long-term.

ESG factors in packaged food
During the year, members of our equity and fixed income teams collaborated on researching ESG factors relating to packaged food. Discussions centered around the prominent issues. Some examples are outlined in the table below.

A key component of these discussions included devising a set of engagement questions to ask companies to use in future joint engagements. Broadly, the questions are designed to gather more detail on the topics listed above, although they are intended to serve as a guiding framework for discussion, not a rigid checklist.

The team also looked across a variety of companies held in our portfolios to identify potentially notable information to help deepen the team’s research and engagement efforts, including:

• An overview of the carbon emissions intensity of meat production companies in comparison to pure play snacks, cereals and confectionary and other products
• The companies that have set or commitment to SBTi targets
• The water reduction programs of these companies
• Examples of RepRisk reports for select companies that highlight the types of differences in geographic exposure and base input commodities that can cause controversies.

The purpose of this collaboration between our equity and fixed income teams was to deepen the team’s understanding of ESG issues in this industry and to strengthen research and engagement efforts from both an equity and fixed income perspective. The team will continue to collaborate on this topic in the coming years.

Sustainability-Themed Bonds
We continue to own sustainable debt across mainstream portfolios, including green, social, sustainability and sustainability-linked bonds.

We purchase green bonds because we believe they represent strong investments for our clients from a risk/return standpoint. Due to the conditions of the bond market in 2022, we spent less on themed bonds than in prior years. However, our exposure to them as a percentage of our overall AUM remained stable when compared to 2021.

In terms of overall issuance, sustainable debt issuance hit $1.5 trillion in 2022 — its first-ever year-on-year drop. This was due in large part to poor macroeconomic conditions, but broader backlashes over greenwashing also tanked supply and demand.

Municipal debt
Given our close relationship with the PRI, members of our municipal fixed income research team and our fixed income ESG analyst served on its Sub-Sovereign Debt Advisory Committee. The committee’s research and deliberations led to the release of an inaugural report on ESG integration guidance for US municipal bonds. The project began in late 2020, and the report was published in July 2021. In 2022, we continued our participation in this committee and collaborated on the second iteration of this report, titled “The Thematic ESG Approach in US Municipal Bonds.” The report highlights the tailwinds that support municipal bond investors’adoption of a thematic ESG approach and the ways in which both labelled and unlabelled municipal bonds can contribute to “sustainability” outcomes. It also covers the state of the labelled municipal bond market and the need for investors to perform due diligence on labelled and unlabelled bonds.

Fixed Income Stewardship
Open communication with issuers is an important aspect of bond ownership. We believe that long-term-oriented asset managers that invest in all asset classes can positively influence governance and business practices as they engage companies by encouraging executive teams to recognize that certain material issues are relevant to an increasingly broad investor base and require further consideration. 

Accordingly, since 2020 our fixed income investment professionals have been included in all issuer engagement meetings conducted by the stewardship team. We believe that these professionals offer a unique perspective and that their inclusion in meetings may serve as a means of encouraging more open communication between issuers and bondholders. In addition to engaging individually with portfolio companies, investors, including bondholders, can participate in industry working groups and organizations that seek to develop thought leadership on emerging issues. When compared to proxy voting and stewardship activities available to holders of equity, opportunities for fixed income instruments and other asset classes are significantly less developed.

At MFS, fixed income strategies in particular represent a large percentage of our assets under management, and so we are continually seeking ways to better assert our rights as owners of an issuer’s debt. In reality, however, the depth of fixed income markets generally and the nature of the typical instruments that we invest in (i.e., larger debt offerings) limit our ability to influence terms or covenants. Our investment team instead focuses on reviewing prospectuses and transactional documents and engaging with management and underwriters prior to investing in order to understand the risks and terms of a debt offering. Based on this analysis, we determine if the investment is in the best long-term interest of our clients. Occasionally, however, when participating in certain debt offerings (typically smaller offerings), we do have more flexibility to assert our influence. This generally takes the form of engaging with management around a proposed waiver of a covenant or adding additional indebtedness. In all circumstances, we agree only to terms that we believe generate or preserve long-term value for our clients. Finally, in extraordinary circumstances, such as a default, we may have the ability to work with an issuer and other investors to help shape a path to recovery or the responsible disposition of the assets. Even in these circumstances, we seek to achieve, when possible, long-term solutions that we believe benefit our clients and are reflective of the good stewardship of capital.

Related links

• Listen to ‘Asking Better Questions: Sustainability in Global Fixed Income
• Listen to ‘Kindness Begets: The Power of Avoidance in Fixed  Income’

MFS may incorporate environmental, social, or governance (ESG) factors into its fundamental investment analysis and engagement activities when communicating with issuers. The examples provided above illustrate certain ways that MFS has historically incorporated ESG factors when analyzing or engaging with certain issuers but they are not intended to imply that favorable investment or engagement outcomes are guaranteed in all situations or in any individual situation. Engagements typically consist of a series of communications that are ongoing and often protracted, and may not necessarily result in changes to any issuer’s ESG-related practices. Issuer outcomes are based on many factors and favorable investment or engagement outcomes, including those described above, may be unrelated to MFS analysis or activities. The degree to which MFS incorporates ESG factors into investment analysis and engagement activities will vary by strategy, product, and asset class, and may also vary over time. Consequently, the examples above may not be representative of ESG factors used in the management of any investor’s portfolio. The information included above, as well as individual companies and/or securities mentioned, should not be construed as investment advice, a recommendation to buy or sell or an indication of trading intent on behalf of any MFS product.

Index data source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Statistics included in this report are calculated based on accounts for which MFS clients have fully delegated proxy voting authority pursuant to the MFS Proxy Voting Policies and Procedures. With the exception of the meetings voted statistics listed on page 47 of this report, all voting statistics exclude instances where MFS did not cast a vote. Statistics also do not include instances where an MFS client may have loaned shares and therefore was not eligible to vote. Statistics are calculated on a meetings-level basis. All engagement statistics listed above include only those managed by the MFS proxy team.

As an active manager, please be advised that the companies named in this report may no longer be held by an MFS client at the time that this report is published.

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.