Research into the impact of ESG on credit portfolio performance
Does the incorporation of environmental, social and governance (ESG) criteria in the investment process improve the financial performance of a bond portfolio or hurt it?
Barclays Quantitative Portfolio Strategy Research team recently investigated the relationship between ESG investing and performance in the US corporate bond markets. The highlights of the findings were:
Introducing ESG factors into the investment process resulted in a small but steady performance benefit. No evidence of a negative impact was found.
Over the historical period of the study, the performance advantage of portfolios with an ESG tilt was not caused by high-ESG bonds becoming more expensive than their low-ESG peers, driven up by excess demand. Thus, we found no evidence to suggest that including high-ESG bonds would cause future underperformance as the prices of these bonds revert back to the prices of their peers.
Of the three scores – E, S and G – the governance score had the strongest impact on performance. Bonds with a high G score also suffered credit downgrades less often than those with a low G score.
The appetite for sustainable investing
In a world where concerns over climate change, pollution and issues of sustainability are ever more pressing, socially responsible investing has become an important consideration for a growing number of individuals and institutions.
Number of UN PRI signatories and their total assets under management
Source: UN PRI
Different investors have different appetite for ESG. For some of the most committed, 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.
Different investors have different appetite for ESG
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.
Financial data, such as accounting statements, alone are no longer regarded as sufficient to measure the health and strength of a company. It is also necessary to consider non-financial drivers of business success.
These can range from environmental (E) issues such as pollution, global warming and energy conservation, to social (S) issues such as work practice considerations and governance (G) issues such as corporate management.
The three dimensions covered by ESG can help make the broad aspiration to be “responsible” more tangible and measurable against a set of objective metrics. Investors and asset managers both rely on independent providers of ESG scores and ratings in their investment decisions. In our study, we used ESG scores from two major providers: MSCI and Sustainalytics.
The investment objective of “responsibility” has different implications for asset owners and asset managers. Asset owners want to make the world a better place by allocating resources to responsible companies while maintaining financial performance.
Asset managers acting on behalf of those asset owners want to be seen as ESG compliant in order to attract ESG mandates and assets, but also need to deliver financial performance to retain those assets.
Which one of E, S or G is most important to asset owners and to asset managers?
Source: Barclays Research, Barclays survey of large fixed income asset managers (2016)
Responsible investors often hope to improve sustainability by engaging with corporates through, for example, proxy voting in shareholder meetings, allocating capital to more virtuous companies and lobbying for changes in regulations and reporting standards.
As ESG factors are expected to play out over a long horizon, responsible investing can also be an encouragement for the managers of public corporations to take a longer-term approach to value creation. This can be a counterweight to the pressure for delivering short-term financial performance if it conflicts with a company’s long-term sustainability.
Why the credit market?
In our analysis of the link between ESG investing and asset performance, Barclays Research focused on the US credit market – rather than equities - for various reasons:
Most ESG analysis relates to equity markets and reflects the perspective of the shareholder, as opposed to the bondholder. Conflicts may exist between these two sets of investors. Our research shows that ESG need not be an “equity-only” phenomenon and can be applied to credit markets without being detrimental to bondholders’ returns.
Many institutional investors, such as pension funds, would like to incorporate ESG in their investment process and bonds represent a substantial percentage of these investors’ assets - by our calculations, more than $10 trillion is invested in corporate bonds globally (based on the weight in the Bloomberg Barclays Global Corporate bond Index). This is only a part of the global credit market with bank loans to corporations being another sizable part especially in Europe.
Corporate bonds are complex: they combine exposures to interest rates and credit spread, so allocations along both dimensions influence risk and performance. Unintended biases can therefore easily appear when overweighting one bond relative to another. Providing a study of ESG performance in credit markets can help bond managers integrate ESG data in their portfolio construction while avoiding any unintended systematic risk exposures.
The details of how an ESG policy is implemented in a portfolio may have a direct impact on its performance.
There is 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 – i.e., those that do less harm to the environment, treat their workers better, and are better managed.
In our study, we constructed diversified portfolios designed to track the US Investment Grade Corporate Bond Index and imposed either a positive or negative tilt to different ESG factors. We 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 0.29% per year and 0.42% per year, respectively.
In addition to the overall ESG scores, we also 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 going forward. We 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.
High-ESG bond portfolios perform better than low-ESG ones
(return differences in % per year)
Source: Sustainalytics: Barclays Research
'Sustainalytics' Governance pillar measures governance of sustainability issues. The firm has a separate Corporate Governance rating that is not represented in this study
Source: MSCI ESG, Barclays Research
The message conveyed by this analysis is that incorporating an ESG tilt in an investment-grade credit portfolio is not detrimental to returns, but can be beneficial – especially where the Governance tilt is concerned. Governance may indeed be a reflection of management quality and, over a long horizon, can benefit bondholders. (Note that both ESG score providers have updated their methodologies over the period of our study. When measured over the most recent history the performance results based on their respective scores are in even closer agreement).
The relationship between ESG scores and credit ratings
We also wanted to establish whether there is a relationship between credit rating, which measures the financial strength of a company, and ESG factors.
In grouping the bonds in the Bloomberg Barclays US Corporate investment-grade index into buckets of low, medium and high ESG scores, we found that:
The average spread of high ESG bonds was 38bp lower than that of the low ESG portfolio for MSCI data and 35bp lower in the case of Sustainalytics.
In both cases, investing in top-tier ESG bonds comes with roughly a one-notch uptick in credit quality.
From these results, it is clear that investors should be careful when integrating ESG data in portfolio construction to avoid unintentional biases in allocation and risk profile. Just overweighting better ESG companies can easily result in lower yields and consequently lower returns.
Looking at whether ESG scores relate to future changes in credit ratings, we found that bonds with high Governance scores (using MSCI data) experienced fewer downgrades than those with low G scores.
Looking at E, S and G factors individually, the credit rating differential between top and bottom tiers was more pronounced for the Environment pillar and almost absent in Governance. This could mean that issuers with higher credit quality (stronger balance sheets) are better able to comply with environmental constraints than those with lower credit quality.
Our Co-Head of Research discusses the report's analysis on CNBC Worldwide Exchange
About the authors
Albert Desclée is a Managing Director in the QPS Group at Barclays Research, based in London, and is responsible for its European activities. He advises investors on portfolio construction, including benchmark selection, risk management, asset allocation, choice of investment style and optimal risk budgeting. Albert joined Barclays in 2008 from Lehman Brothers, where he had the same responsibilities.
Prior to joining Lehman Brothers’ research department, he worked at Salomon Brothers in London, where he was in charge of fixed income index analytics and portfolio construction advisory. Albert graduated from the Catholic University of Louvain (Belgium) and obtained an MBA from INSEAD.
Lev Dynkin is Managing Director, founder and Head of the Quantitative Portfolio Strategy (QPS) Group at Barclays Research. Dynkin and the QPS group joined Barclays in 2008 from Lehman Brothers where the group was a part of Fixed Income Research since 1987. QPS focuses on bespoke research related to quantitative issues of portfolio management for major institutional investors around the globe.
Dynkin joined Lehman Brothers Fixed Income Research from Coopers & Lybrand where he managed financial software development. Dynkin began his career doing research in theoretical and mathematical physics. He is based in New York.
Jay Hyman is a Managing Director in the QPS group at Barclays Research. Jay advises clients on mandate design and efficient portfolio construction and management, relative to traditional benchmarks or liabilities. He has published research on topics including risk budgeting, performance attribution, portfolio optimization, cost of constraints, sufficient diversification and index replication; these studies have covered asset classes spanning fixed income, FX, equities, hedge funds and derivatives.
Jay joined Barclays in October 2008 from Lehman Brothers, where he held a similar position. He holds a Ph.D. in Electrical Engineering from Columbia University in NY.
Simon Polbennikov is a Director in the Quantitative Portfolio Strategy group. He advises institutional investors on quantitative aspects of portfolio management. Mr. Polbennikov is responsible for empirical studies on investment strategies, hedging, portfolio construction, and benchmark customization.
He joined Barclays in October 2008 from Lehman Brothers where he held a similar position. He received a PhD degree from Tilburg University, Netherlands. Prior to that, he studied physics at Lomonosov's Moscow State University, Russia and economics at the New Economic School, Moscow.