ESG investing in fixed income assets will no longer ‘lag behind’ equities as the sector wakes up to importance of sustainability, research by BlackRock suggests.
According to the asset manager’s latest report, ‘Sustainability: The Bond that Endures’, the “why not?” moment in sustainable fixed income investing has arrived as the need for ESG solutions across the asset class becomes more pressing.
“The equity market has played an early role in sustainable investing, while bond markets have lagged in data, tools and insights. But that’s changing fast.
“New ESG indexes have created building blocks that can be used to bring sustainability into the core of portfolios, even in asset classes such as emerging market (EM) debt that until recently lacked sustainable solutions,” the report states.
BlackRock said its analysis suggests ESG may serve as a proxy for quality in fixed income.
Analysing bonds by ESG score in the European credit universe, using MSCI’s ESG data, the fund manager found the bottom quintile (poorest ESG performers) traded at a spread around 25 basis points (bps) higher than the top quintile as of mid-2019.
In other words, poor ESG performers typically must compensate investors with higher spread premiums, and vice versa.
This in turn implies excluding issuers with the lowest ESG scores from a bond portfolio may result in a tilt to lower-risk — and lower yielding securities.
“Might this lower a portfolio’s returns over time? Our research suggests not. We studied the performance of the euro corporate index referenced above over the past three years.
“The top quintile of ESG performers outperformed the bottom quintile by around 50 bps cumulatively, despite its lower average yield. This bolsters our conviction that a tilt toward stronger ESG performers in fixed income need not entail sacrificing return objectives,” the report said.
However, the research highlighted there will be certain ‘nuances’ to investing sustainably in bonds, with sovereign debt requiring a different approach to equities.
“In contrast to equities, fixed income investors’ main focus is often on mitigating downside risk, rather than capturing upside potential. We believe ESG metrics can help identify new risk factors,” the report adds.
Moody’s analysis in September 2018 revealed around 11 sectors with $2.2 trillion in rated debt were at risk of credit downgrades due to their exposure to environmental risks such as carbon transition.
The electric utilities and coal sectors faced the most immediate risks, with auto makers, oil and gas, and commodity chemicals makers facing threats on a three-to-five year horizon.