ESG and Fixed Income—a Natural Fit

Both quantitative and qualitative research suggest bonds issued by companies with favorable environmental, social and governance (ESG) ratings can offer downside mitigation during periods of market turbulence.

Art by Jon Han

Investors in the U.S. are warming to the idea of using environmental, social and governance (ESG) considerations when building out their portfolios.

Research from Morningstar finds most investors, across ages and genders, have clear preferences for ESG-conscious investment products. Morningstar suggests that 72% of the United States population expresses at least a moderate interest in sustainable investing. Institutional investors, similarly, have expressed a good measure of their own cautious but significant interest in ESG topics.

Increasingly, investors’ ESG considerations are moving beyond the equity side of the portfolio. In fact, 33% of respondents to one survey say it is important to incorporate ESG into fixed-income investing. Asked directly whether they incorporate ESG into fixed-income management, 52% of U.S. investors that already use ESG say “yes.”

ESG Considerations Offer Valuable Fixed-Income Insight

In a recent analysis on this topic, Brad Camden, director of fixed income strategy, Northern Trust Asset Management, and Manan Mehta, senior quantitative research analyst, propose that sustainable investing themes and bond portfolios “make for a good marriage because risk is a key focus for both.”

“Bonds help manage risk through lower correlation and volatility versus equities,” the pair writes in “Sustainable Investing in Fixed Income: Avoiding the Pitfalls.” “Sustainable investing aims to mitigate damage from climate change, poor labor relations and fraudulent accounting practices, among other sources.”

Camden and Mehta present evidence suggesting that bonds issued by companies with favorable ESG governance ratings tend to trade at tighter credit spreads and have longer durations.

“We find that bonds with higher ESG ratings offered downside mitigation during periods of market turbulence despite their loose relationship to traditional credit ratings,” Camden and Mehta write. “This suggests that investing in companies with the highest ESG ratings may offer further downside mitigation above and beyond what their credit ratings would suggest. In other words, ESG considerations may provide an alternative long-term lens to evaluate credit.”

Like others writing and speaking on the topic, the pair emphasizes the importance of doing proper due diligence while investigating any new investment strategy. They say all bond investors who explore the world of sustainable investing should do their homework and have a strong understanding of ESG factors and the drivers of long-run bond returns before any taking any significant actions. Simply investing in top-rated ESG companies or applying a standard screen of some industries could be “fraught with unintended yield, duration, sector and country risks.”

“Uncertainty remains around the timing, nature and magnitude of ESG risks,” they explain. “While keeping ESG in mind, investors should still focus on the primary drivers of fixed-income returns, such as key rate duration, sector, issuer and option adjusted spread.”

Camden and Mehta observe that European companies tend to be ESG leaders, while U.S. companies are often laggards. They also warn that it is extremely difficult at this stage to model implications of climate change on asset prices.

“Increasingly, asset owners are lowering exposure to both fossil fuel reserves and carbon emissions as the first line of defense against the transition risk associated with climate change,” they write. “In doing so, investors should not only focus on historical measures of carbon footprint. They should also favor companies that are taking steps to mitigate low carbon transition risks through renewable energy and clean technology—in addition to other forward-looking measures.”

A Growing Consensus

Northern Trust’s take is far from unique. PIMCO, for example, has published a white paper reaching similar conclusions, titled “ESG Investing and Fixed Income: The Next New Normal?

Gavin Power, PIMCO’s chief of sustainable development and international affairs, says the institutional and retail investing marketplace is witnessing a growing recognition that ESG issues present material credit risk, with respect to both corporate and sovereign debt. He adds that PIMCO’s integration of ESG credit analysis across the entire investment universe “reflects the understanding that investors, like any lender, cannot ignore sustainability and governance issues that may affect a borrower’s ability to repay its debt.”

According to PIMCO’s analysis, the materiality of ESG issues in relation to credit risk “follows naturally from the growing body of evidence demonstrating, for example, that companies that effectively manage and integrate sustainability issues realize a range of competitive benefits, including resource and cost efficiencies, productivity gains, new revenue and product opportunities, and reputation benefits.”

PIMCO further finds that, on both the product innovation and sourcing side, fixed-income ESG is accelerating.

“Numerous ESG bond funds have been launched—or are in the works—by both mainstream institutions and boutique houses,” Power observes. “Meanwhile, PIMCO engagement and discussions with both corporates and sovereigns suggest we are on the cusp of a sea change in social bond securities related to issues such as water access, sanitation, gender, health and other social-related infrastructure areas (e.g., food distribution, transport).”