Adding value through ESG analysis in corporate bonds
What should corporate bond investors expect when integrating environmental, social and governance analysis (ESG) into their investment process? Combining active management with active engagement provides the scope for investors to do ‘the right thing’ and make money.
The evolution of ESG investing
The earliest adopters of an ethical approach to investment focused on screening out companies that did not meet a determined value threshold. Investors generally accepted that this approach should, on average, be expected to produce lower than index returns due to the smaller investment universe. Indeed, when we started the European Corporate Bond Sustainable and Responsible Investment Fund in 2012 in cooperation with a Dutch pension fund, we thought we would be swimming against the tide.
In practice, the fund has outperformed the benchmark. Individual credit selection has been the main driver of performance. However, an important lesson has been that ESG analysis is a fundamental ingredient in understanding the risks of a company, alongside traditional credit analysis.
ESG analysis is integrated into our investment process. This is not simply driven by the desire to do the right thing. Good stock selection within a credit portfolio means avoiding downgrades. There is evidence of a link between good management of ESG risk and good management of the financial risks that determine the creditworthiness of a company.
Active engagement: equities versus bonds
It is often assumed that fixed income investors have little scope for active engagement with companies because they do not have a vote. As a company, we put great emphasis on the active use of proxy voting, but see it as only one of five potential levers. Four others are available to bond investors.
- A constructive dialogue can add value to both the investor and the company.
- Investors can clearly set out the information they require to assess ESG risks, helping companies to improve the reporting – and through this the management – of their activities.
- Portfolio managers can harness the power of the media to broadcast their message more widely, putting pressure on company management to make changes.
- Active investors can buy or sell bonds. This is what ultimately separates active and passive management.
Voting is the one lever that is available only to equity investors. However, fixed income investors who sit alongside equity investors can form a joined-up approach to governance issues.
Equity and bond investors are also faced with different risks. The Deepwater Horizon disaster initially hit both the equity and bond prices of BP. For equity investors, tens of billions of value have been destroyed through ongoing compensation payments and clean-up costs. But, from a credit perspective, coupon payments did not stop and the balance sheet remained healthy.
Current trends in ESG investing
There has been increasing focus on ‘green bonds’ in recent years but, this year, growth in issuance has stalled. Green bonds are a source of funding for projects that address the challenges of climate change. However, there is no single definition of a green bond. Indeed, Tianjin SDIC Jinneng Electric Power used a green bond issuance to finance a coal-fired power station in 2017, illustrating a conundrum of these securities. While this is an extreme example, the nature of the projects that are financed by these bonds mean they are more – not less – exposed to environmentally-related risks. Perhaps this helps explain the slowdown in their issuance.
Impact investing is also gaining increased attention. Impact investing involves buying the securities of companies that have the intention of generating positive social and environmental impacts alongside financial returns. Again, there is no single definition, which is slowing its adoption. We use key performance indicators attached to the UN’s Social Development Goals to measure the progress of companies that we monitor.
Quantitative investors are increasingly incorporating ESG ratings from independent data providers into their investment selection process. Some academic studies have identified that ESG factors have not been fully factored into security prices and could provide a persistent (but not permanent) source of excess returns. However, we find examples where the ratings do not make sense. For example, one data provider ranks Russian banks as less risky than US banks. The reason is that Russian banks have been hit by fewer scandals. But that is readily explained by the fact that the US banks are a multiple of the size of their Russian peers. And press freedom means that scandals in Russia are less well publicised.
Local regulations are also driving a change in investor behaviour. The French parliament passed a law in 2015 that requires institutional investors to disclose the carbon footprint of their portfolios. In August of this year, the US state of California passed a bill that requires the country’s two biggest pension funds –the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS) – to consider “climate-related financial risk” when making investment decisions from 2020.
Two macro trends are influencing our strategy. The first is a normalisation of monetary policy. The European Central Bank is in the process of winding down its programme of bond buying – or quantitative easing – which will cease at the end of the year. 10-15% of this buying has targeted corporate bonds and this has supported those bonds that are eligible for purchase. This tapering by the central bank will negatively affect the supply /demand balance and therefore we are cautious on those eligible bonds.
Second, we remain cautious on Italian bonds due to political risks. The hotly debated state budget proposals from the populist Italian government coalition are now on the table. They are likely to be closely scrutinised in the markets in terms of underlying revenue and expenditure assumptions. Challenges from the EU commission are also a potential source of volatility. In particular, we are underweight in non-financial bonds, where higher quality issues are yielding less than equivalent government bonds, even for domestic businesses.
The normalisation in monetary policy is expected to send government bonds yields higher. However, interest rate rises are expected to be gradual, not least because of the delicate situation in Italy. History tells us that a gradual rise will not lead to a widening of credit spreads.
We find value in hybrid bonds, where individual security selection is vital. Orsted, a Danish operator of offshore windfarms, offers an attractive yield for a strong credit. A long-held position in the portfolio, bond investors have benefited from an improving ESG rating. The disposal of the company’s oil and gas exploration business has reduced the cyclical risks associated with energy prices. It also removes the risks of the company being left with stranded assets should legislation on oil and gas extraction change.
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