New research confirms what proponents of incorporating environmental, social and governance (ESG) criteria in fixed income investing have long understood: investing in fixed income issuers with better ESG scores leads to improvements in both performance and risk mitigation.
The study, conducted by MSCI Research, adds to the body of evidence that will encourage more ESG integration in the fixed income asset class.
That means an acceleration of a shift that’s already been underway, though ESG in fixed income still lags behind the far-more-established use of ESG in equity investing.
The research is detailed in a new report and summarized in a blog post, here. MSCI researchers looked at bonds from nearly 1,500 corporate issuers over a six year period ending last June, taking into account each issuer’s ESG scores as well as its credit rating. They then calculated the market performance of each issuer’s corporate bonds.
The data was clear, the paper says: the issuances coming from corporates with higher ESG scores had better risk-adjusted returns — thanks to both higher excess returns and lower excess risk — than the lower-scoring issuers. The high ESG rated issuers “also had significantly lower drawdowns during the downturn periods, indicating the inherent defensive characteristics of an ESG strategy.”
One important takeaway is that fixed income investors and portfolio managers should be taking ESG factors into account, just as they have long looked at credit scores. A steadily increasing number are already doing so, but now proponents have even more evidence to back them up.
Also noteworthy is the study’s unequivocal finding: “Risk reduction was clear with high ESG issuers,” MSCI Research executive director Hitendra Varsani, who co-authored the report, said on a recent CleantechIQ webinar. More than that, he added, risk reduction was much higher in the environmental and social pillar scores than in the governance pillar.
The research findings seem certain to fan the flames for further ESG growth across fixed income portfolios. As Russell Investments notes in a recent report, “While ESG was initially a hot topic for equity investors, fixed income market investors are taking notice and practitioners are quickly catching up.” Russell, which itself has been incorporating ESG factors into its bond portfolios since 2014, says it has seen a “rapid expansion in ESG integration practice among fixed income asset managers in recent years.”
And a growing number of fixed income investors are “embracing the [ESG] agenda as a key initiative,” Russell adds.
ESG in fixed income started out among plain-vanilla investment-grade corporate bonds, but it’s moved well beyond that. Yoshie Phillips, the firm’s director of investment research for global fixed income, is seeing managers bring ESG tilts into strategies that span the fixed income universe.
“There’s a broader product offering, outside of investment-grade corporate credit,” Phillips said on a recent CleantechIQ webinar. “There’s a hunger among institutional investors to expand ESG beyond straight corporate bonds and into other fixed income sectors,” including high-yield, bank loans, emerging markets debt, sovereign bonds and municipal bonds.
The bulk of the hunger, though, seems to still be for ESG-focused corporate bond strategies. That was on vivid display in October, when Taiwan’s Labor Pension Fund made a big move into fixed income ESG investing. The pension allocated $2 billion to the space, split evenly among five ESG managers: DWS Investments, Insight Investment Management, JP Morgan Asset Management, Pimco and Western Asset Management. A sister fund, the National Pension Insurance Fund, hired the same five managers for $60 million allocations each. All are for ESG-focused corporate bond strategies with an ESG tilt.
In November, the Ontario Teachers’ Pension Plan issued a €750 million ($908 million) green bond, with the proceeds to go toward projects that are environmentally and socially responsible and that fight climate change. That follows the Canada Pension Plan Investment Board’s issuance of a €1 billion green bond in early 2019, with the proceeds going to renewable energy, water and other such projects.
Big US pensions are looking at ESG in fixed income too. To take just two recent examples, in July, trustees at the California State Teachers Retirement System approved a plan to focus on green bonds, social bonds and sustainability bonds and other ESG-related fixed income instruments. The pension giant had more than $300 million invested in such bonds as of March. Also in July, the San Francisco Employees Retirement System decided to invest $400 million in a Pimco multi-sector bond fund, also with an ESG focus.
In fact, Pimco has made a strong commitment to integrating ESG into its entire investment process. The company is “systematically incorporating environmental, social, and governance factors into our broad investment process that touches the nearly $2 trillion of assets that we manage,” says Olivia Albrecht, the firm’s head of ESG business strategy. That includes strategies like credit, sovereign debt, municipal bonds and securitized assets.
Pimco also offers ESG-dedicated strategies, which are “designed to target traditional Pimco-style risk-adjusted returns while also targeting sustainability objectives,” she adds.
Albrecht says the firm is “committed to leading the way in ESG fixed income through innovative strategies for clients, engagement with bond issuers, and industry collaboration to elevate market standards.” She adds that she hopes investors will “join us in bringing ESG past the rhetoric and into action in bond markets.”
Indeed, the word “innovation” is commonly heard around this sector. “The ESG market is innovating and is really exciting in fixed income,” Michael Kashani, global head of ESG portfolio management for fixed income at Goldman Sachs, said at a recent CleantechIQ event on the sector. “This is one area where our equity counterparts are jealous of us.”
Consultants report similar findings. ESG is in fact becoming “increasingly prevalent in fixed income markets,” according to Kristin Bradbury, senior vice president in Callan‘s Independent Adviser Group. “More investment managers are applying ESG analysis to bonds, and many have developed customized ESG frameworks to specifically evaluate various segments of the global credit markets.”
Callan expects the growth in fixed income ESG strategies to continue, Bradbury says. “We are seeing an increase in the number of managers that are incorporating ESG metrics into broad fixed income strategies, as well as an increase in thematic, impact-oriented strategies.”
There are challenges, of course. Some revolve around data accessibility or transparency, though practitioners report good progress on these fronts in recent years. “ESG-specific information is increasingly available in the marketplace,” the Russell report reads. But, it adds, it’s not perfect yet. “Getting access to ESG-related data and digesting such information into one’s investment process are an evolving investment practice.”
And investors and managers are still figuring out the best way to engage with their fixed income portfolio companies, since owning a bond or other fixed income security doesn’t bring voting rights. Here, too, the market seems to be sorting out the issue and making real progress.
One important point, according to MSCI, is that while credit ratings have always been important in fixed income investing, and remain so today, ESG scores are not just riding credit scores’ coattails. “We found that ESG ratings had characteristics distinct from credit ratings and delivered financial value after accounting for credit ratings. In short, the two types of rating systems complemented each other,” the report says.
And while past performance is, of course, no guarantee of future returns, it seems certain that research like MSCI’s will bolster the continued growth of ESG in fixed income. As MSCI Research’s Varsani put it on the CleantechIQ webinar: “ESG has actually delivered outperformance quite consistently across many markets.”