Vice proves hard habit to kick as ESG enters credit markets

Companies in sectors that many ESG funds would exclude, such as tobacco, fossil fuel and gaming companies, can still access credit markets with relative ease, investors say.


Virtue in corporate environmental, social and governance debt is becoming lucrative for investors and companies alike, but vice still has its rewards in the hunt for yield. Companies in sectors that many ESG funds would exclude, such as tobacco, fossil fuel and gaming companies, can still access credit markets with relative ease, and sometimes even lower their funding costs, investors say.

The trend of linking borrowers’ debt repayments to ESG criteria remains relatively new. There are enormous variations in standards for everything from recycling targets to employee diversity goals. Investors’ willingness to police those guidelines also differs. And the rewards for compliance or the consequences of failure is simply too paltry.

“ESG pays off, but not always necessarily short term,” said Chris Brils, a portfolio manager at Actiam, estimating the penalties for a failure to comply with such criteria at around five to 10 basis points. “It’s nothing that significant yet.”

There’s also the worry that excluding companies or sectors that haven’t embraced the ESG agenda may hurt returns.

Chris Bowie, a partner at TwentyFour Asset Management in London who helps oversee more than 16 billion pounds ($22 billion), found that returns dropped by 1% a year when he stripped out companies in the oil and gas, tobacco, gambling and alcohol sectors while testing his first ESG fund. The exclusions also increased the fund’s volatility as a result of a lack of diversification among assets.

[More: COVID-19 helps drive record-level ESG bond issuance]


Bowie, who launched a sustainable short-term bond fund in January 2020, said being an ESG manager can be challenging as corporate policies are wide open to interpretation and beliefs about sectors can be personal.

“We have spoken to investors who for religious reasons see no issue in having companies that make alcohol in the fund, and others that will say nuclear power is acceptable,” Bowie said. “Opinions can range across cultures, religions and regions.”

In a previous role as head of European high-yield credit at ABN Amro Bank, Brils said he wasn’t allowed to buy the debt of Netherlands-based Imperial Tobacco, but was able to invest in German arms manufacturer Heckler & Koch, which supplies the U.S. military.

“So I could buy the GI in Iraq a new gun but not allow him a pack of smokes,” Brils said.

The complexity of ethical investing is compounded by companies promoting an ESG agenda regardless of the nature of their product.

For example, Kloeckner Pentaplast, which makes plastic packaging, links the cost of its debt servicing to its greenhouse gas emissions, the amount of recycled material in its products and the number of women in senior roles.

The difficulty of choosing ethical credits have led some to denounce ESG as a fraud.

“In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community,” Tariq Fancy,former chief investment officer of sustainable investing at BlackRock Inc., wrote in a column for USA Today.


Interpretations of what’s palatable may vary widely, but there are limits to what some investors can stomach.

Heckler & Koch was forced to raise the funds it needed in the more expensive private credit market three months after it mandated Citigroup Inc. for a high-yield bond sale in 2017.

In 2019, lenders struggled to find buyers for a $500 million loan that they agreed to provide to NSO Group, an Israeli hackers-for-hire company that disputed accusations that one of its products was used by countries to spy on dissidents, including a friend of murdered Saudi journalist Jamal Khashoggi. The banks were left holding the loan and had to sell it at a steep discount, people familiar with the situation said at the time.

Companies in the so-called sinful category haven’t so far had to pay much if any penalties when raising new debt, but Actiam’s Brils expects change soon as more fund managers are forced to comply with ESG-related investment strategies.

Ironically, when borrowing costs do begin to increase for “vice” firms, the credit sector may outperform its peers as investors find the returns too attractive to ignore.

“There will always be investors that for whatever reason do not want to go down the ESG road, and that is their prerogative,” Bowie said.

That those assets may ultimately offer higher yields “is exactly the point of ESG,” he said. “It’s a good thing as it gives investors greater choice.”