by Jonathan Bailey, Head of ESG Investing, Neuberger Berman
ESG is relevant to bonds as well as equities, but in different ways.
Investors instinctively understand how weak corporate governance can be linked to poor financial performance. Whether it is wasting shareholder capital on expensive acquisitions, a board that is insufficiently independent to challenge a CEO’s failing strategy or an audit committee that lacks the expertise to ensure the accounts are a full and fair representation of the financial health of the company, the ways in which governance failures can damage the bottom line are many and various.
Yet the environmental and social aspects of ESG investing are just as linked to financial value creation—just think of the businesses that are building the sustainability solutions of the future.
Productivity growth has been the main driver of the economy in the post-war era; a manufacturer that produces an aircraft engine that uses less fuel per seat mile or a tech company that can automate and network analytical tasks to the cloud so that they can be processed by highly efficient data centers is creating dollars and cents for its customers and supporting broader economic growth.
Patterns of demand are shifting, too. Consumers increasingly want to know that their cell phone was made in a supply chain that protects worker safety, or that their morning coffee is served by a company that actively embraces diversity in its workforce.
Re-thinking Assumptions
Companies don’t invent highly efficient new products, audit their supply chains or introduce a culture of inclusion overnight. It might take several years for these efforts to bear fruit—but once built, they may form sustainable competitive advantages.
This may be part of the reason why ESG investing has historically been most robust among public equity investors—they can identify management teams who are taking these steps early, invest with a long-term perspective and participate in the potential upside.
Fixed income investors, concerned to get their coupons and principal over the next couple of years, might feel they needn’t worry about these factors. Perhaps they would argue that it’s enough to consider the governance of the issuer to ensure that capital allocation will be disciplined, the board will be independent and their claim on the cash flows will be protected.
Perhaps. But more and more fixed income investors are re-thinking these assumptions. Investors in sovereign debt have been innovators in understanding the importance of environmental and social indicators and their correlation to the ability of a sovereign to service their debt. Now more corporate fixed income and credit teams are taking these factors into account, changing the sort of ESG data that companies are being asked to disclose.
Think about that cloud computing company that is bringing more and more data onto its highly efficient servers. Certainly confidence in the likelihood of growing free cash flows is relevant to the fixed income investor, but they will also want to ask other questions. How is data privacy and cybersecurity being handled? Would a significant public attack undermine customers’ willingness to continue placing data onto the cloud? What if regulators in one region impose stricter data sovereignty rules requiring the company physically to relocate its data centers?
These risks could materialize suddenly, blowing out credit spreads or, in a worst-case scenario, jeopardizing the ability to pay back corporate bondholders.
Short-term Risk, Long-term Sustainability
To put it another way, integrating environmental and social concerns into an investment process is about assessing both short-term risk to, and the long-term sustainability of, a business model.
Bondholders and equity investors will want to consider both aspects, but the transmission mechanism of how a given environmental or social factor impacts valuation of different parts of a company’s capital structure will be different. That in turn means the questions each analyst will ask of management and the data they use to assess the quality of the business may differ.
In a 2016 study, Barclays analysts took the 5,000 or so bonds in the Bloomberg Barclays US Corporate Investment-Grade Index that had ESG ratings from ESG-rating providers MSCI and Sustainalytics, and constructed pairs of portfolios that differed in terms of their ESG ratings, but were otherwise near-identical1.
Between 2009 and 2016, the hypothetical backtested portfolio with the positive ESG-rating tilt generated a small but persistent advantage. This advantage did not come from any systematic tightening of credit spreads in the high-rating portfolio, but rather from the difference in the number and magnitude of credit-rating downgrades. The governance component of the ESG rating was, as might have been expected, the most correlated to performance advantage, but environmental and, to a lesser extent, social ratings were associated with a performance advantage.
In a separate study, Bank of America Merrill Lynch looked at whether ESG ratings would have helped investors avoid the worst-case scenarios of corporate bankruptcies2. Of the 17 companies within the U.S. BofAML universe that had filed for bankruptcy since 2008 and were ranked on ESG scores for at least five years prior, 15 had below-average environmental and social ratings.
This makes sense—sudden changes in environmental regulations, or a spill or explosion caused by poor safety practices are the sorts of tail events that can jeopardize ability to service debt. But these analysts also found that governance ratings were weakly correlated to bankruptcies, which seems counterintuitive, particularly given the Barclays findings. Even primarily social and environmental catastrophes are often preceded by, and facilitated by, governance failures.
Developing Fixed Income-Specific ESG Models
As the Bank of America Merrill Lynch authors suggest, this may indicate that the data points going into the “G” scores of current ESG models are missing something vital for assessment of catastrophic credit risk. Might this be because those data points have been designed for equity analysts, focusing on issues such as shareholder rights and board independence?
These studies are fascinating in that they tell us that there may be some alpha potential for bond investors even from using off-the-shelf ESG ratings primarily built for public equity investors, while also telling us that these models may be missing key things that bond investors need to know.
This is why fixed income analysts are becoming more sophisticated at developing and using their own ESG assessments, often customized through engagement directly with management. Neuberger Berman is among a number of firms that has also been working with the ratings agencies S&P and Moody’s to encourage them to place a greater focus on considering material ESG issues in their rating methodologies.
As the industry makes progress in these areas, ESG investing will begin to acknowledge the distinct dynamics of each part of a company’s capital structure, and could generate new insights to be shared between fixed income and equity analysts. The foundations will be built so that ESG could become a fully integrated and genuinely holistic tool in portfolio management.
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