Shared growth and risk: An eye on bonds

Investing is attuned to the notion of risk. It’s one of the first concerns investors raise about a new investment. It’s one of the first characteristics advisers attempt to ascertain when sitting with a new client. Risk is part and parcel of investing. So where does investing inspired by shared value sit on the continuum?

In 2016 Barclays Research attempted to glean answers to such questions in a report entitled Sustainable Investing and Bond Returns. The study delved into the impact of environmental, social and governance (ESG) considerations on credit portfolio performance over a seven-year period. The research marked a shift from equities, which have been extensively covered with regard to the impact of ESG, towards bonds. Far less is still known about responsible investing in the bond market.

In investigating the link between ESG and corporate bond performance, Barclays Research constructed broadly diversified portfolios tracking the Bloomberg Barclays US Investment-Grade Corporate Bond Index. They matched the index’s key characteristics (sector, quality, duration) but imposed either a positive or negative tilt to different ESG factors.

In the study, Barclays Research constructed diversified portfolios designed to track the US Investment Grade Corporate Bond Index, a popular benchmark for institutional asset managers investing in the US credit market, and imposed either a positive or negative tilt to different ESG factors.
In April 2016, said the report, “this index included 5 675 bonds from 761 different issuers. We only considered bonds with ESG scores from both [investment research firm] MSCI and Sustainalytics [an independent global provider of ESG and corporate governance research and ratings to investors], reducing the sample size by about 10%.” The bonds were grouped into high, medium and low ESG buckets and then compared based on the MSCI and Sustainalytics data.

The results found that:

• In comparing the excess returns of a high-ESG portfolio with a low-ESG one, the high-ESG investment outperformed steadily using data from both Sustainalytics and MSCI. The return advantage over the past seven years averaged: 29% per year and 0.42% per year, respectively.

• In addition to the overall ESG scores, Barclays Research tested the effects on performance of the separate E, S and G scores from these two providers. Despite their different approaches to evaluating issuers, a very similar pattern is observed for both: Governance had the strongest link, followed by environment. Social scores had the weakest link with performance; for one provider, the high-S portfolio slightly underperformed the low-S portfolio.
• One explanation for the steady outperformance of high-ESG bonds over the past seven years could have been that increasing interest in sustainable investing has driven up the prices of these bonds, potentially making them less attractive.The researchers carried out tests to measure this ‘ESG spread premium’ and found that this has not been the case – high-ESG bonds (as measured by either provider’s scores) have not become more expensive. In short, how an ESG policy is implemented in a portfolio may have a direct impact on its performance. And, therefore, on the risks which could derail a company over the long term.

Takeaways

• Business strategy is central to shared value, as it talks to the decisions a firm makes to align its business to the needs of society.
• While environmental, social and governance (ESG) factors are a narrower focus within a business strategy, they too seek to promote efficiencies and manage risk.
• In the world of investing, ESG factors need not be an ‘equity-only’ phenomenon and can be applied to credit markets without being detrimental to bondholders’ returns.
• Recent Barclays Research findings show that a positive ESG tilt resulted in a small but steady performance advantage.
• ESG attributes did not significantly affect the price of corporate bonds. No evidence was found that the performance advantage was due to a change in relative valuation over the study period.
• When applying separate tilts to E, S and G scores, the positive effect was strongest for a positive tilt towards the governance factor, and weakest for social scores.
• Issuers with high governance scores experienced lower incidence of downgrades by credit rating agencies.

“A poor environmental record may make a firm vulnerable to legal action or regulatory penalties; mistreatment of workers may lead to high turnover, low productivity, or poor quality work; poor corporate governance can give management wrong incentives or increase the likelihood of accounting irregularities,” said the report. By extension, a sustainable investment should not be detrimental to the broad ecosystem in which it operates. So sustainability can been seen at two levels: sustainability of the investment and sustainability of the world.”

The study also noted a key distinction between an ESG approach based on negative screening by industry and one based on relative comparisons of the firms in each industry. For example, an investor using a negative screen may choose to exclude coal-mining companies from their investment universe.

Another investor may use ESG ratings to rank coal-mining companies, and choose to invest in the ones that have the best overall ranking within the sector. In the first case, in a year in which coal mining companies outperform the market the investment portfolio may lag a broad market index. In the second approach, the portfolio is neutral with regard to the systematic sector exposure, but favours those companies with better ESG policies – for example, those that do less harm to the environment, treat their workers better, and are better managed.
Ultimately, the message conveyed by the Barclays analysis was that incorporating an ESG tilt in an investment-grade credit portfolio is not detrimental to returns, but can be beneficial – especially where governance is concerned. As Jeff Meli, Co-Head of Barclays Research, said at the time of the report’s release: “Our analysis demonstrates that an appropriately designed bond portfolio, tilted towards companies that have high scores in ESG factors, not only doesn’t cost investors but actually drives up performance.”

Why? Because, says Meli, these companies are fundamentally performing better: “Particularly companies that score well on governance factors tend to get downgraded less than other companies, and obviously in corporate bonds downgrades are a big risk factor.”

This holds lessons for investors and client trading around the world as, at various speeds and with differing degrees of enthusiasm, ESG becomes increasingly part of how we measure organisations. “[ESG is] becoming more and more popular. Increasingly investors are looking to their financial portfolios to be very aligned with their values,” says Meli, “and so we are seeing very rapid growth in these sorts of mandates. Particularly when you can show that it doesn’t cost you to align your portfolio to your values, we think that is going to lead to even more rapid growth.”

An appetite for sustainable investing in a world where concerns about equality, climate change, pollution and issues of sustainability are increasingly more pressing, socially responsible investing has become an important consideration for a growing number of individuals and institutions, believes Barclays. Different investors have different appetites for ESG. For some, knowing that the funds in which they invest will help make the world a better place is so important that they are willing to accept a lower return on their investments. A much larger group would be happy to support these values if they could be convinced that their commitment would not result in underperformance, or additional risk. Either way, both positions require a different way of assessing and understanding companies and their long-term potential in order to fit the demands of increasingly socially-aware investors.

For Saloshni Pillay, MD: Head Client Solutions at Absa Corporate and Investment Bank, in order for companies to be successful and improve exponentially, “creating Shared Growth must be at the forefront of their respective mindsets. Tough economic conditions generally mean financial institutions become more conservative around risk. However, if we applied shared-value thinking and the concept of risk-sharing more broadly, we could find sustainable solutions to existing problems.” This supports the Barclays Research view that: “If the sustainable investing tilt can actually help to improve portfolio performance, it would be hard to justify not adopting it. The relationship between ESG characteristics and performance is therefore of primary importance.” Pillay points to General Electric as a worthy example of how creating Shared Growth by tackling existing problems is a win-win for the community and the company, as well as a risk mitigation tool for investors. “[At General Electric] executives realised the challenges of global health represented one of the company’s greatest opportunities for growth in the coming years,” says Pillay. “The business is investing US$6 billion to develop new, inexpensive products and treatments that meet the health needs of low-income populations around the world, with a goal of reaching 100 million new patients every year.”

For investors, examples such as this offer insights into a new, sustainable way of assessing companies. The reaction to the Barclays Research report shows the interest in this approach quite clearly, with Meli and Barclay’s Quantitative Portfolio Strategy (QPS) team noting the following: “The QPS team fielded many questions on the ESG report from investors around the globe, as well as through one-on-one discussions with client teams. Interest in this research remains strong with a growing number of investors looking to align their portfolios with their values. In turn, this is forcing portfolio managers to implement ESG factors in their credit portfolio management framework. We believe ESG investing is a long-term trend, not only because investors want to align their investments with their values, but also because the ESG tilt may have positive risk and performance implications on a credit portfolio.”

At a global level Barclays notes “an increase in the number of our asset manager clients starting to offer ESG funds. More broadly ESG attributes are increasingly being considered alongside other financial metrics to form investment decisions.”