This article is a part of NordSIP Insights – Handbook – “Sustainable Fixed Income – 2019”.
by Mamadou-Abou Sarr, Director of Product Development & Sustainable Investing and Manan Mehta, Senior Quantitative Research Analyst, Northern Trust Asset Management
Combining sustainable investing and fixed income has the potential to deliver attractive long-term returns while delivering positive change. However, there are risks with doing so in a naïve way. Here’s how to avoid them.
The ESG Advantage in the Bond Market
Sustainable investing 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. Sustainable investing aims to mitigate damage from climate change, poor labor relations, and fraudulent accounting practices, among others.
Bonds issued by companies with favorable environmental, social and governance (ESG) ratings tend to trade at tighter credit spreads and have longer durations. Based on our research and as presented in Exhibit 1, we find that bonds with higher ESG ratings offered downside mitigation during periods of market turbulence despite their loose relationship* to traditional credit ratings.
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. Credit ratings agencies are starting to take notice by exploring ways to incorporate environmental and climate change risks into their decisions.** That said, uncertainty remains around the timing, nature and magnitude of ESG risks. 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.
Watch for Biases
Bond investors who explore the world of sustainable investing should perform their due diligence and have a strong understanding of both ESG factors and the drivers of long-run bond returns. Taking a naïve approach by simply investing in top-rated ESG companies or applying standard exclusions of some industries could be fraught with unintended yield, duration, sector, and country risks. Investors should take intentional risks, and ensure they are compensated for those risks, to achieve the outcomes they seek.
For example, ESG ratings are based on rankings within industries independent of country and sector. As Exhibit 2 illustrates, yields of ESG leaders tend to be lower, which may cause portfolio yield to fall short. Also, as shown in Exhibit 3, European companies are the most common ESG leaders while U.S. companies are often laggards. This could lead to too much emphasis on French companies and introduce sovereign risk. Standard exclusion practices may present problems as well. Screening for controversial weapons, fossil fuel reserves, and tobacco among others could introduce unintended sector weightings. Given these biases, combining ESG with fixed income means that investors should take appropriate risk controls for duration, spread, country and sector risks while favoring companies that are stronger than peers.
Climate Change: Look Forward, Not Back
It is extremely difficult to model implications of climate-change to asset prices. But increasingly asset owners are lowering exposure to both fossil fuel reserves and carbon emissions as the first line of defense against the transition risks associated with climate change. 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.
Avoiding the Pitfalls: Consider Factor Investing
In order to further bolster fixed income outcomes, our research shows that precisely targeting factors such as quality, value, size, momentum and low volatility has historically improved fixed income returns.*** Exhibit 4 shows the performance of the top 20% (based on our proprietary fixed income score) of each of the factors relative to the global corporate credit benchmark.
Combining factors with ESG can provide both positive risk and return outcomes while investing responsibly. So investors don’t have to sacrifice performance to invest sustainably. In fact, combining high financial performers that also value sustainable business practices makes as much business sense as it makes good sense.
Guidelines to Get Started
As investors consider sustainable investing for their bond allocation, they should keep in mind these key ideas:
- Sustainable investing may be used when seeking to improve performance and manage risk in a fixed income allocation.
- Duration, spread, country and sector biases can manifest when adding sustainable investing or ESG into the investment process and they should be controlled for.
- ESG ratings should be considered as an additional factor to evaluate an issuer’s long-term creditworthiness.
- Style factors such as quality and value may be combined with ESG factors to potentially improve risk-return outcomes.
These guidelines should provide a solid foundation when considering integrating ESG to your bond portfolios.
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