One Bond Manager’s Work to Expand ESG

Editor's note: This article first appeared in the Q1 2021 issue of Morningstar magazine. Click here to subscribe.

Parnassus Investments, founded in 1984, is one of the oldest U.S. fund managers focused on environmental, social, and governance investing, and it’s the largest, with more than $35 billion in assets. The San Francisco-based firm has gained recognition for its standout equity ESG strategies, most notably flagship Parnassus Core Equity PRBLX and Parnassus Mid Cap PARNX, both of which have Morningstar Analyst Ratings of Silver for their two share classes.

Parnassus Fixed Income PRFIX, the firm’s only fixed-income offering, has been a small part of overall growth, with less than $400 million in assets. However, the strategy is gaining recognition since Samantha Palm joined the firm.

Palm herself is an exception at Parnassus. The employee-owned firm, which earns an Above Average Parent Rating from Morningstar’s manager research team, has steadily grown from the ground up, with analysts starting as interns and portfolio managers rising from the ranks. Palm, however, was hired as a portfolio manager in 2013 to ramp up the firm’s fixed-income efforts.

“The internship is critically important to the research team, but there wasn’t the structure to do that for fixed income,” Palm says. “As a result, I’m the only one on the team without an internship, but I like to joke that my interview process was my internship. I came in every week for six weeks in a row. They got to know me pretty well.”

Seizing Opportunities Palm got her first taste of the fixed-income markets as a child from her mother, who ran a regional trading desk at a Chicago bank. "On school holidays," she says, "I went to work with my mother, and I would run trade tickets for her."

The family eventually moved to New York, but Palm returned to the Midwest for college at the University of Wisconsin-Madison and began her career as an equity research analyst at eminent Milwaukee investment bank Baird.

“I learned a lot about how companies operate and about how businesses are built, but it was a research role, and I felt pretty removed from the decision-making process,” Palm says. “I wanted something that was more action-oriented.”

A sales and trading position at Wells Fargo Securities’ fixed-income group in San Francisco prompted her switch to fixed income in 2008. “That was a rocky period of time,” Palm laughs. “I started in April of 2008, and I like to say that I’m not afraid of the markets because I cut my teeth on a derivatives desk during the financial crisis.”

Then came the opportunity at Parnassus in 2013. “The main reason I was drawn to Parnassus was the integrity of the firm and the true intellectual curiosity here,” Palm says. “Our investment process is to continue to dig deeper, questioning our decisions and our answers. And, of course, there’s the integrity that comes along with ESG.”

Given the necessary pandemic precautions, Palm has been working from her home across the Golden Gate Bridge in Marin County. With many other obligations canceled, it’s been an opportunity for her and her husband to pursue their passion for the outdoors with their three young children. They camp, visit local and national parks, and like to get off the beaten path, even with kids in tow; the family recently went paddleboarding in a lagoon off the coast with leopard sharks swimming below.

“It has been wonderful to be able to do these kinds of activities, and we are fortunate to live in a place with this availability of outdoor recreation,” Palm says.

That said, she misses her work team, and Zoom meetings have become key to the investment process. “I love being part of a team. It’s critically important to me,” Palm says. “I spent the first few years at Parnassus working to more deeply integrate the fixed-income fund within the broader team so that it wasn’t a fixed-income island.”

Refining the Process Before Palm joined the firm in 2013, the fixed-income fund seemed something of an afterthought, though a serviceable vehicle for clients who wanted a socially conscious bond option. About two thirds of the portfolio was in U.S. Treasuries, with the rest invested in bonds of companies also held on the equity side of the shop. Today, the fund places more emphasis on corporate bonds. While most of these issues are also held in the equity funds, some are unique because the team especially likes the fixed-income attributes.

Parnassus excludes from its focus list, or investment universe, companies that derive significant revenue from alcohol, tobacco, weapons, nuclear power, gambling, and fossil fuels. That last screen drew New York-based advisory firm Gitterman Wealth Management, which offers fossil fuel-free model portfolios for a significant number of clients who request them.

Adam Bernstein, Gitterman’s lead ESG impact analyst, says that Parnassus’ approach met the advisory firm’s demanding criteria: “Parnassus has invested very meticulously, and they study their own carbon footprint and carbon intensity.”

The investment team refines its focus list using ESG, quality, and valuation screens. They then look for companies with sustainable competitive advantages, increasingly relevant products or services, exemplary management, and ethical practices. The managers then develop bull-, bear-, and base-case scenarios, preferring investments that have narrow ranges of potential outcomes.

Palm is now thoroughly embedded in the investment team. As the firm has grown, it has built out smaller sector teams, and Palm sits on them all. Her comanager since May 2020, Minh Bui, is a longtime Parnassus analyst who leads three of the sector teams.

“Parnassus is a dynamic organization,” says Kate Campbell King, CIO of North Berkeley Wealth Management, based in Berkeley, California. She has worked with Parnassus since the 1990s and seen the investment team evolve. “There’s a lot of continuity with the team, and it’s nice the way they bring in new people and include them.”

Palm chairs Parnassus’ fixed-income committee, which meets weekly to monitor the fund’s top-down strategic positioning. In addition to Palmand Bui, the committee includes Parnassus CIO Todd Ahlsten and deputy CIO Matt Gershuny (portfolio managers on the Core Equity and Mid Cap funds, respectively), as well as risk assessment specialist Isaac Macieira-Kaufmann.

“As my co-PM Minh likes to say, we would rather be generally right than precisely wrong. So, we don’t forecast exactly what we think rates or spreads are going to do over the next 12 months,” Palm says. “As a committee, we plot out a range of outcomes for each asset class, capitalizing where we see opportunity and trying to minimize areas where we see risk.”

The fund homed in on corporate bonds starting in late 2016 and held a stake of about 70% of assets until mid-2019. But valuations on corporates stretched, while Treasury yields were quite high relative to the team’s expectations. By early 2020, the fund was down to 40% in corporate bonds.

This recent underweight in corporates is an exception to the rule, however. Over the longer term, shareholders can expect a tilt toward corporates of about 70% because of those securities’ superior yield and because investing in corporates allows the strategy to leverage the research of the broader Parnassus team.

“We’re able to really lean into ESG by having such a heavy overweight to corporates,” Palm says.

Active Engagement Because shareholder activism via proxy voting is an important part of ESG investing, the approach may not seem as intuitive for fixed income. But ESG is also about assessing opportunities and risks that other measures don't account for.

“If you think about the attributes of fixed income, you could argue that an ESG framework is even more important,” Palm says. “The upside is limited, but the downside is real, so you need to think about downside protection, which means you should be thinking about ESG risks. We do think ESG helps us find particular issuers that are going to excel relative to their peers.”

Sarah Green, director of impact investing for North Berkeley Wealth Management, agrees that Parnassus’ approach gives it an edge: “We believe that adding an ESG approach to fixed income helps minimize downside risk, but ESG integration on the fixed-income side is not as prevalent. Parnassus leverages its research.”

Activism is also part of the approach, even though fixed-income investors don’t have the voting rights that stock shareholders do. “Obviously we’re engaging in partnership with our equity colleagues,” Palm says, “but we also engage with companies that are unique to the corporate bond portfolio, which is about one third of the issuers in the portfolio.”

This is one reason that Gitterman Wealth Management prefers active managers like Parnassus to passive options: “ESG is not a one-signal type of data set,” Bernstein says. “Active managers can take a much more nuanced approach with the data and use it as a starting point to ask deeper questions of the companies themselves.”

A current priority for Parnassus is racial and gender equity. “It’s similar to greenhouse gas emissions 10 years ago. We didn’t expect companies to report fantastic data. We wanted to understand where they stood and then advocate for science-based goals for emissions reductions. That’s where we are today with equity engagement,” Palm says. “I help lead these conversations to show companies that this is important to me as a portfolio manager.”

The aim is progress, not perfection. In a recent Q&A with advisors, one questioned Parnassus’ investment in Amazon.com AMZN. “There’s work to be done with Amazon, but they have changed their tune, and they are willing to put a lot of capital toward ESG factors,” Palm explains. “It’s about continuous improvement. We are better advocating for change than sitting on the sideline.”

Says King, “We see that as a big benefit.

Parnassus has curated a set of investments, but they are then continuing the conversation.”

Because of this level of engagement, the fund often holds bonds of the same companies for years. One example is

“We looked at their core plumbing and paint businesses and saw that there really wasn’t much volatility associated with those businesses, even during the depths of the financial crisis,” Palm says. Masco then divested the other businesses, leaving the company well positioned going into the pandemic, which has boosted home improvements. “Now, they’re investment-grade, leverage is down, and cash flow has significantly improved.”

In this tight yield environment, Palm is taking advantage of idiosyncratic trading opportunities, such as those caused by the Federal Reserve’s actions in early 2020 and the steepening yield curve. She is also selectively extending duration with some issuers while still keeping overall duration in line with the index. The team recently moved into longer-term Pentair Finance bonds. “We’ve known the management team for years,” says Palm. “We understand how they’re trying to improve operations, and we believe they’re going to continue to do that.”

Investing for Good About 10% of the portfolio is in green bonds earmarked for environmental projects. Half of this stake is in supranational bonds from organizations such as the World Bank, which issued the first green bond in 2008. Palm says that these aren't simply feel-good investments; there's aninvestment case for them as well.

“We view them as sort of a Treasury replacement for part of our portfolio,” she says. “They have a little bit better yield, and we get a triple-A rating, but they’re typically less volatile than Treasuries because they’re not part of a global currency network. And all the proceeds are going to high-impact projects to the most vulnerable parts of the world.”

The rest of the stake is in bonds issued by companies on Parnassus’ focus list, such as shopping center REIT

“I talk to companies about where they’re going to be applying the proceeds from a green bond. These can be good ROIC (return on invested capital) projects,” Palm says. “If a company is reducing its greenhouse gas emissions, the easiest way to do that is to reduce electricity usage, and that drops to the bottom line.”

The fund also holds corporate sustainability bonds, where proceeds may be used for social purposes.

Drawing Attention These kinds of investments appeal to North Berkeley's clients, Green says: "They want to feel confident that they are doing well for society and the environment and at the same time achieving investment outcomes."

The strategy has been getting notice on both fronts. “Since we refined how we manage the fund in late 2016, we’ve had good performance. We’re also one of the few fixed-income funds that fully incorporate ESG, which has driven client interest and fund inflows,” Palm says.

From 2017 through 2020, the fund’s lower-cost institutional share class beat its benchmark, the Bloomberg Barclays US Aggregate Bond Index, and the investor share class comes close. (Expense ratios are 0.45% and 0.68%, respectively.) The fund’s returns have also been competitive in recent years within the intermediate core-plus Morningstar Category.

While the fund has performed in line with core bond offerings, the portfolio does not include some core fare, such as mortgage-backed securities, King cautions: “We don’t use it as our only bond fund. We pair it with mortgage exposure and some additional impact exposure, as well as highly liquid investments.”

On top of improved performance, the fund’s Morningstar Risk scores have consistently been below average. Bernstein says risk control is key for Gitterman’s clients: “They want to know that ESG data has been used in the risk-mitigation process. Many investors are older individuals, or institutions with less of a risk appetite, so a lot of their assets tend to be in fixed income.”

He adds that even investors not explicitly interested in an ESG mandate would be well served by the fund. He believes that in a transition to a low-carbon economy, fossil fuel exposure is a significant investment risk going forward.

Under Palm’s direction, Parnassus Fixed Income is making the case for ESG fixed-income investing.