ESG is positive for fixed income returns

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The United Nations-supported Principles for Responsible for Investment (PRI) has come a long way since its April 2006 launch. In a little over a decade it has grown from 100 to over 1,700 signatories from more than 50 countries representing US$62 trillion of funds.[1]

Initially at least, the PRI and incorporating environmental, social and governance (ESG) factors into investment processes and decision-making may have been regarded as a fringe issue in some quarters, but today they are absolutely mainstream.

The widespread adoption of ESG[2]  has been made possible by a subtle but important change in emphasis and understanding.[3] Early adopters were ethically motivated investors focused on environmental and social issues while many institutional investors observed for any signs of negative impacts on portfolio returns. 

The key to gaining widespread traction has been in challenging the perceived effect on performance.  Not only is it no longer assumed that “doing the right thing” will be a drag on portfolio returns; rather, it is seen as positive for returns.

At the same time, it is now seen as prudent to avoid investing in companies that have a detrimental impact on their local communities and the environment or which are poorly governed, because their business practices may not be allowed to remain unchanged[4] and resulting imposts to alter behaviour could further diminish companies’ financial performance.

Said differently, investing in ESG transgressors creates a double-whammy possibility for investors. A first hit to performance as the errant company’s deeds come to light and second blow as it has to take corrective action.

See Our approach to ESG for a summation of the way our Global Liquid Strategies (GLS) team incorporates ESG into the investment process and comments on collaboration with key stakeholders to advance responsible investing in Australia.  We also make the affirmative case for ESG in the same section under ESG is positive investing, it’s not about exclusions.

Responsible investing a “should do” in Australia

In Australia, the increasing attention on responsible investing goes beyond the UN PRI charter and performance-related motivations. The ASX Corporate Governance Council Principles and Recommendations, first introduced in 2003, with the most recent update released in March 2014,[5] APRA’s thinking[6][7] as well as legal opinion on directors’ duties, mean that ESG-related practice is a “should do.”

To be more specific: recommendation 7.4 of the ASX Corporate Governance Council Principles and Recommendations states that: “A listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks.”[8]

As for those who may not want to follow recommendations; the document requires an “if not, why not” statement in a public company’s corporate governance statement explaining its reasons for not following a recommendation.[9]

By the same token, APRA has made it clear “that the days of viewing climate change within a purely ethical, environmental or long-term frame have passed.”[10] Instead, the Regulator is calling for entities that fall within its purview to develop comprehensive approaches on how they plan to deal with climate change across dimensions including reporting, monitoring, and managing physical as well transition risks.[11]

In that spirit, in November 2016, the Centre for Policy Development and the Future Business Council released an influential legal opinion on company directors’ legal obligations to consider the impacts of climate change.

The opinion found that “company directors who fail to properly consider and disclose foreseeable climate-related risks to their business could be held personally liable for breaching their statutory duty of due care and diligence under the Corporations Act. The opinion’s author, a Senior Counsel, warned it is “only a matter of time” before we see this sort of litigation against a director.”[12]

All-in-all, the responsibilities carried by organisations and individuals with financial and investment management responsibilities are a far cry from just a generation ago.  Consequently, the broader range of issues that fall under the umbrella of responsible investing/ governance/ESG are considerations alongside other more traditional investment factors. At the very least, not taking ESG issues into account is becoming a challenging position to defend.

That’s why ESG standings are now regarded as measures of risks facing companies stemming from good/poor behaviour in the environmental, social and governance spheres and the language used to describe these attributes has evolved towards terms that have positive connotations regarding long-term investment performance.[13]

Need for fixed income specific perspective

That said, up until recently, the relationship between responsible investing and investment performance has been largely equity market focused. Similar studies on the responsible investing/fixed income relationship have been rare.  

This is unsatisfactory as fixed income is not a subset of equities. It requires specialised analysis. With that context, this paper owes a great debt to academics who have given attention to the ESG/fixed income relationship as well as the work of Barclays.[14]

It’s a little surprising that the bond market/sustainable investing relationship has been under-examined as bond markets would seem to be eminently suitable for this kind of research.

The US corporate debt market, for instance, is a very large (around US$8.5 trillion outstanding market debt during the fourth quarter of 2016), very active (with an average daily investment grade trading volume of US$18.5 billion and US$11.5 billion in high yield for calendar year 2016) and dynamic (with new investment grade bond issuance reaching US$1.43 trillion and US$216 billion in high yield during 2016 vs. US$197.5 billion total equity issued in the same year).[15]

Furthermore, because, in general, companies need to refinance themselves in the debt market more frequently than in the equity market (due to the finite maturity of bonds), the former appears to be more suitable for active investors and other stakeholders to implicitly exercise stakeholder activism and companies would be inclined to meet their demands or suffer higher debt costs.[16]

Corporate bond markets are also more of an institutional investor’s arena in comparison with the equity market. Around 93 per cent of US corporate bonds are institutionally owned while the equivalent percentage for US equity is about 59 per cent[17].

The institutional investor view on ESG is especially important as institutional investors are generally believed to be better informed than private investors and because of this it is more likely that they will take into consideration complicated issues such as ESG when allocating the funds they manage.[18]

Second, high institutional participation decreases free float bonds (i.e., increases the concentration of bonds in the hands of a relatively small number of investors), and this should make it easier for bondholders to “discipline” company management when they need to by simply selling the respective corporate bonds, hence increasing the cost of debt for transgressing firms.[19]

Finally, corporate bonds are complex. They encompass interest rates, credit spreads, coupons and term structures and the multitude of issues within them requiring forensic precision. All this would seem to point towards an institutional perspective.

esg-rating-puzzle


Stakeholder theory and VW example

Before providing evidence for the positive relationship between higher ESG ratings and superior fixed income performance, it’s useful to touch on the abstract association between the two transmitted by the concept of “stakeholder theory.”

Arguably, there are stakeholders who attempt to infer a firm’s underlying corporate character according to its ESG record. If this perception of corporate character is deemed to be one of a trustworthy and cooperative entity, then it can result in a significant competitive advantage.[20]

It makes intuitive sense that a company that is responsible in its interactions with society, exhibits strong corporate governance practices and thoughtful in its treatment of the natural environment is more likely to enjoy greater customer loyalty, increased employee attraction and retention rates as well as productivity, and, finally, have superior access to capital compared with a firm that does not pay attention to its social posture.[21]

By contrast, a firm that is found to behave irresponsibly on ESG dimensions risks a higher probability of negative events occurring such as employees withholding best efforts,  a decrease in social license to operate, increased regulatory scrutiny, potentially government sanctions,  and associated legal costs.[22]

Such events could lead to a higher cost of debt for the transgressing company. The example of the Volkswagen (VW) emissions scandal that erupted in September 2015 is a powerful case in point.

The German carmaker found itself in the firing line when the United States Environmental Protection Agency (EPA) charged it with violation of the Clean Air Act over 2009-2015 by installing software that deceived official emissions testing. Market reaction was swift and savage (Figure 3)

VW credit default swaps blew out to more than 250 basis points versus mid-70s prior to the news, while the company’s share price plunged more than 30 per cent overnight. MSCI’s ESG rating for VW fell to CCC from BBB, ranking it among the worst in the industry.


VW


QIC GLS’ flagship Australian fixed income portfolio was underweight VW exposure prior to the scandal announcement.  VW’s below-peer MSCI ESG rating in the years prior to the transgression was a significant factor in our decision, as was the group’s relatively tight credit spreads. The view that VW’s spreads didn’t adequately compensate investors for credit and ESG risks meant that our active underweight contributed nicely to excess returns upon the dramatic widening in VW’s spreads.

Once the spreads widened we evaluated the risk and management’s commitment to rectifying the emissions issues.  Our detailed assessment identified value in the bonds at the wide levels thus we purchased the bonds and enjoyed the rally into mid 2016.  We saw little further upside in the bonds at that point given the ongoing litigation risk and sold out of the position.

All this adds up to the contention that the default probability and loss severity of bondholders’ investments in firms that expose themselves to ESG transgressions is higher than investments in companies with better practices.[23]

Two propositions naturally grow from all this. The first is that firms with more ESG strengths have lower credit spreads (lower cost of debt financing) and higher corporate bond ratings (lower default risk). Secondly, firms with more ESG-related concerns have higher credit spreads (higher cost of debt financing) and lower corporate bond ratings (higher default risk).[24]

Findings from industry and academic research

Now it’s time to go beyond assumptions to discover what industry and academic research actually reveals by starting with Barclays’ work.

To examine the responsible investment/corporate bond performance relationship, they used as their universe the Bloomberg Barclays US Corporate Investment-Grade Index, a widely quoted benchmark for institutional asset managers investing in the US credit market.

In April 2016, around the time Barclays’ study was carried out, this index included 5,675 bonds from 761 different issuers.  Barclays’ only considered bonds with ESG scores from both MSCI and Sustainalytics, which reduced the sample size by about 10 per cent.[25]

Key findings from Barclays were:

  • Most portfolio pairs (high-ESG minus low-ESG portfolios) delivered a positive return, indicating a generally positive return premium for the “ESG factor” in corporate bond markets. The cumulative excess returns of the high-ESG over the low-ESG portfolio from August 2009 to April 2016 was almost 2 per cent.[26]
  • Governance had the strongest link with performance and Social the weakest, being even associated with slightly negative returns. Environment is in between. So the intuition of investment professionals that governance is more important to portfolio risk and return than the other two dimensions of ESG is validated in the analysis.[27]

The investment significance of governance underscores our belief that negative screening is insufficient; it is at odds with our ESG principles. The exclusion of entire industries may be short-sighted and does not allow us to be agents of change.

The revelation that Governance had the strongest link with performance is especially important as it is a factor that bottom-up credit analysts have long valued. We firmly believe credit needs to be assessed and actively managed.  It’s reassuring to know that even before the formal advent of ESG, fixed income and credit professionals were looking at the correct issues when analysing companies and issuers. Governance is a proxy for quality and risk while the inclusion of the Environmental gauge provides another analytical lens. 

See Are E, S and G equal or are some more equal than others for a discussion on the investment performance influence of each of the ESG factors.

As active managers, we know that neither credit ratings nor ESG ratings are the Holy Grail.  Experience, understanding the macro outlook and getting your hands dirty in balance sheet analysis are vital.  To this we add that incorporating an ESG tilt in an investment-grade credit portfolio is not detrimental to returns, but can be beneficial.

Academic studies support case for responsible investing

Findings from academic studies are broadly consistent with both our own experience and Barclays’ research.

The Friede, Busch and Bassen study combined the findings from about 2200 individual studies and found “…that the business case for ESG investing is empirically very well founded. More importantly, the large majority of studies reports positive ļ¬ndings. Promising results are obtained when differentiating for portfolio and non-portfolio studies, regions, and young asset classes for ESG investing such as emerging markets, corporate bonds, and green real estate.”[30]

More than two-thirds of cases researched by Friede, Busch and Bassen uncovered significant positive performance relations to ESG criteria.[31]

Likewise, Feng Jui Hsu and Yu-Cheng Chen found “that social responsible firms have lower credit spreads and lower default risk.”[32]

Additionally, Feng Jui Hsu and Yu-Cheng Chen’s work “showed there is a negative and significant association between CSR[33] score and forward default probability. In addition, good CSR companies have very low short-term default probability and forward default probability.”

 

“Using CSR performance information assembled by KLD[34], we find that better CSR performance scores appear to provide crucial information that can reduce financial risk. Furthermore, positive CSR performance scores appear to be associated with reduced financial risk while negative CSR performance scores lead to increased financial distress. In addition, analysis shows that positive CSR performance has a greater impact on rating score forecasts than does negative CSR performance. That is, firms with good CSR performance enjoy reduced credit risk, corporate bond spreads, and bankruptcy risk. This suggests that investors are more likely to respond to positive CSR information than negative CSR information.”[35]

The outlook for ESG and fixed income returns

These findings thus far are all well and good, but it does raise the issue of the efficient markets hypothesis. Can corporate bond portfolios with high ESG scores (thus lower default risk) provide attractive returns?

Firstly, the market may not be efficient on ESG considerations yet.  ESG ratings in the fixed income arena are relatively new and credit investors are not as attuned to ESG ratings as their equity peers, nor are they as familiar with ESG ratings as they are with corporate credit ratings.  This will change over time as ESG becomes more mainstream in the fixed income realm.  We think excess returns can be generated for those with the skill to assess ESG criteria and apply both positive and negative screening across portfolios. 

Secondly, let’s assume the market was perfectly efficient. High ESG scoring companies have lower default and downgrade risk and thus they would exhibit tighter credit spreads than low ESG companies all else being equal.  An investor observing this and not taking ESG considerations into account would therefore consider the safer names “too tight”.  Risk-adjusted returns should be the focus of attention and that requires comprehensive understandings of industries and companies, and not ignoring ESG considerations.

The efficient market hypothesis assumes that investors perfectly price all information that is currently available.  A key advantage of a strong ESG rating is a company’s ability to deal with new information.  Strong governance and social conscience should make a firm more flexible and therefore better able to cope with unforeseen challenges.  Strong environmental conscience should help a firm mitigate environmental issues and deal with new regulations

It’s important to note that like corporate credit ratings, ESG ratings are not a “be all and end all” for spreads and pricing.  For us, this presents opportunity and the potential, with quality credit analysis and eyes on all three facets (environmental, social and governance) to reap extra return potential. Strong analysis of corporate balance sheets, the macro-economic outlook and industry health remain essential to credit selection.

Investors of all stripes intuitively know that companies that act responsibly are more likely to perform well financially as well as be supported by the communities they are part of. As fixed income investors, it’s encouraging to be validated by academic research and the beginnings of investment industry analysis.

As ESG considerations reveal themselves over the long haul and become increasingly important in the investment management industry, they may also help to alleviate the pressure for short-term performance and by doing so foster a greater emphasis on value creation for assets owners and the world at large.

ESG

For more information:

Craig Balenzuela CFA

Head of Business Development – Australia 
Level 34/52 Martin Place, Sydney NSW 2000

PO Box R1413 Royal Exchange NSW 1225

T  +61 2 8045 8001

+61 417 684 154

E  c.balenzuela@qic.com

 

Chris O’Connor

Senior Business Development Director
Level 34/52 Martin Place, Sydney NSW 2000

PO Box R1413 Royal Exchange NSW 1225

T  +61 2 9347 3380

+61 401 567 792

E  c.oconnor@qic.com

Andrew Arkell

Director Business Development – Queensland 
Level 7 Central Plaza Two, 66 Eagle Street

GPO Box 2242 Brisbane Qld 4001 Australia

T +61 7 3360 3856

M +61 419 735 791

E a.arkell@qic.com


David Redford-Bell

Business Development Director

Level 7 Central Plaza Two, 66 Eagle Street

GPO Box 2242 Brisbane Qld 4001 Australia

T +61 7 3360 3824  

M ++61 490 429 419

E d.redford-bell@qic.com 

   

Ryan Gordon
Director - Investment Specialist, Global Liquid Strategies

Level 7 Central Plaza Two, 66 Eagle Street

GPO Box 2242 Brisbane Qld 4001 Australia

T +61 7 3020 7016

M +61 434 605 056

r.gordon@qic.com

Gillian Gibbs

Investment Specialist - Global Liquid Strategies

Level 7 Central Plaza Two, 66 Eagle Street

GPO Box 2242 Brisbane Qld 4001 Australia

T +61 7 3020 7152  

M +61 401 088 285

E g.gibbs@qic.com  

 

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For more information about QIC, our approach, clients and regulatory framework, please refer to our website www.qic.com or contact us directly.

The statements and any opinions in this document (the “Information”) are for commentary purposes only and do not take into account any investor’s personal, financial or tax objectives, situation or needs.  The Information is not intended to constitute personal legal or investment advice and it does not constitute, and should not be construed as, an offer to sell or solicitation of an offer to buy, securities or any other investment, investment management or advisory services. Past performance is not a reliable indicator of future performance.

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[1] https://www.unpri.org/about. Accessed 12 April 2017

[2] The terms ESGresponsible investing and sustainable investing are used interchangeable in this document.

[3] Sustainable investing and bond returns: research study into the impact of ESG on credit portfolio performanceImpact Series 01. Barclays.

[4] Ibid.

[5] Corporate Governance Principles and Recommendations, 3rd Edition, ASX Corporate Governance Council, 27 March 2014. Accessed

[6] APRA’s regulatory radar. Speech by Helen Rowell, Deputy Chairman to the Conference of Major Superannuation Funds (CMSF), 2017 Sydney. http://www.apra.gov.au/Speeches/Pages/APRA's-regulatory-radar.aspx. Accessed 15 May 2017.

[7] Australia's new horizon: Climate change challenges and prudential risk. Speech by Geoff Summerhayes, Executive Board Member 17 February 2017 to Insurance Council of Australia Annual Forum, Sydney. Accessed 15 May 2017.

[8] Corporate Governance Principles and Recommendations, 3rd Edition, ASX Corporate Governance Council, 27 March 2014. Accessed

[9] Ibid.

[10] Australia's new horizon: Climate change challenges and prudential risk. Speech by Geoff Summerhayes, Executive Board Member 17 February 2017 to Insurance Council of Australia Annual Forum, Sydney. Accessed 15 May 2017.

[4] Corporate Governance Principles and Recommendations, op cit.

[11] Ibid

[12] Ibid.

[13] Sustainable investing and bond returns. 01 Impact Series. Barclays

[14] Key sources documents for this paper are: The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings, Ioannis Oikonomou, Chris Brooks and Stephen Pavelin, The Financial Review 49 (2014) 49–75. The Eastern Finance Association 2014; ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Gunnar Friede, Timo Busch and Alexander Bassen, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917, link http://dx.doi.org/10.1080/20430795.2015.1118917); Is a firm’s financial risk associated with corporate social responsibility?", Feng Jui Hsu and Yu-Cheng Chen (2015) Management Decision, Vol. 53 Issue: 9,pp. 2175-2199, permanent link to this document: http://dx.doi.org/10.1108/MD-02-2015-0047Sustainable investing and bond returns: research study into the impact of ESG on credit portfolio performanceImpact Series 01. Barclays.

[15] All data in this paragraph from Securities Industry and Financial Markets Association (SIFMA).

[16] The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings, Ioannis Oikonomou et al.
[17] United States Federal Reserve data.

[18] Ibid.

[19] Ibid.

[20] This paragraph from The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings, Ioannis Oikonomou et al in turn references Jones, T.M., 1995. Instrumental stakeholder theory: A synthesis of ethics and economics, Academy of Management Review 20(2), 404–437.

[21] The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings, Ioannis Oikonomou et al.

[22] Ibid.

[23] Ibid and reference in that work to Bauer, R. and D. Hann, 2010. Corporate environmental management and credit risk. Working paper, European Centre for Corporate Engagement.

[24] Ibid.

[25] Sustainable investing and bond returns: research study into the impact of ESG on credit portfolio performance.  Impact Series 01. Barclays

[26] Ibid.

[27] Ibid.

[28] Ibid.

[29] Ibid.

[30] ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Gunnar Friede, Timo Busch and Alexander Bassen, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917, link http://dx.doi.org/10.1080/20430795.2015.1118917
[31] Ibid.

[32] Is a firm’s financial risk associated with corporate social responsibility?", Feng Jui Hsu and Yu-Cheng Chen (2015) Management Decision, Vol. 53 Issue: 9,pp. 2175-2199, permanent link to this document: http://dx.doi.org/10.1108/MD-02-2015-0047
[33] CSR is “Corporate social responsibility
[34] Kinder, Lydenberg, Domini (KLD) Research and Analytics, Inc
[35] Is a firm’s financial risk associated with corporate social responsibility?", Feng Jui Hsu and Yu-Cheng Chen.

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