Barclays’ studies have produced mixed results on the link between performance and ESG factors for bonds. In a 2015 study, Barclays Research concluded the wholesale exclusion of entire industries from the investment universe for ethical reasons, for example, was not justified in purely financial terms.
A 2016 study into the impact of ESG on credit portfolio performance, Sustainable investing and bond returns, found the return associated with a high governance score had been both high (5.5% of cumulative outperformance) and persistent over the previous seven years. It concluded, therefore, that: “Our research into the impact of ESG on the performance of US investment-grade corporate bonds in the past seven years has shown that portfolios that maximise ESG scores while controlling for other risk factors have outperformed the index, and that ESG-minimised portfolios underperformed.”
The evidence regarding the link between ESG factors and credit risk is perhaps more compelling. Barclays found bonds with low governance scores experienced a consistently higher rate of subsequent downgrades than those with high scores throughout their study period.
ESG IN CREDIT RATINGS
The credit rating agencies (CRAs) are key influencers in the fixed income value chain and have a large role to play in reflecting ESG risks in how they rate companies. Significant progress has been made in this regard in recent years, especially following the work by the UN Principles for Responsible Investment (PRI) to create guidelines for best practice in factoring ESG risks into credit ratings.
“Investors are changing their view of ESG and, given the importance of the credit rating agencies, they should be part of that conversation,” says Archie Beeching, senior manager, fixed income and infrastructure at the UN PRI. Their work has seen eight CRAs and 112 investors commit to transparency in considering ESG factors.
CRAs are critical for two reasons. Firstly, fixed income investment is still dominated by passive, index-tracking funds, but it is not necessarily the job of the index provider to apply that ESG analysis. (Specific ESG bond indexes are growing in popularity, but the total capital tracking these benchmarks, in which the index providers take a more selective approach to inclusion is still relatively small). As a consequence, investors passively following mainstream fixed income benchmarks could be exposed to unrewarded risk if ESG factors are not appropriately built into the credit rating process.
Secondly, the CRAs’ ratings directly affect the cost of capital available to companies. Thus, companies that are heavy polluters or are poorly governed should pay a higher price for borrowing because it has a material impact on creditworthiness. This sends a powerful message to the corporate world that is reliant on debt as part of its permanent capital structure.
More needs to be done in this regard. As Laura Nishikawa, executive director of ESG research at MSCI, says: “ESG is not systematically brought in to CRAs’ day-to-day ratings. It will take a long time to get to that.”
BONDHOLDER ENGAGEMENT
Engagement by creditors with corporates is another important factor in improving the performance of fixed income portfolios and is an area that is growing. Bondholders, however, report some degree of frustration in their engagement efforts, which is arguably more limited than for shareholders who are able to use their voting power to influence company management. For many bondholders, their key opportunity to exert influence is at the point of primary issuance.
“Creditors’ maximum influence is at primary issuance, where they can negotiate on terms and covenants,” says Bluebay’s Ngo. “We start a dialogue at primary issuance, but if we find, over time, that a company is not managing a credit-relevant risk, we will engage with them and encourage them to change their practices.”
