Sustainable credit: ESG is key

Properly assessing a company’s environmental, social and governance standing gives credit investors an edge. It’s become the norm for equity investors and now, ESG analysis is also beginning to gain traction in the fixed income market. Ultimately, we believe that a clear understanding of company ESG profiles gives investors a material edge in surfacing the gems from a broad and deep pool of corporate credits.

ESG investing isn’t just a matter of moral goodness, but increasingly it’s a fiduciary duty. ESG criteria offer insights into a company’s prospects that corporate accounts alone can’t. For anyone investing in corporate bonds, ESG should be at the heart of the search for tomorrow’s winners.

That’s because bondholders are starting to realise that the non-financial aspects of a business’s performance can have a lasting effect on its creditworthiness and invisibility. There is, for instance, a growing body of academic research that broadly shows a positive correlation between how well a company rates on ESG metrics and its cost of capital.

ESG factors come into play from various directions – government regulation is taking on ever more environmental and social dimensions, the public are increasingly turning away from companies that are unethical or polluting, and investors are becoming more sensitive to the potential for reputational risks.

At the same time, new techniques and metrics are emerging to help analyse the non-financial factors that had hitherto been overlooked because they couldn’t be measured, but which carry material risks.

Clearly, there’s a way to go before all aspects of ESG are fully embedded in fixed income investing. Investors considering responsible investment strategies remain consumed by the fear of sacrificing returns although experience shows a properly constructed ESG approach should be able to generate excess returns and help avoid pitfalls.

Indeed, the impact governance can have on the performance of corporate and sovereign bond issuers has long been clear. There are innumerable case studies of companies that have suffered from management failures. Strong governance is associated with a lower incidence of credit rating downgrades. Analysis shows that credit portfolios of companies with high rankings for governance outperformed those with low rankings by a substantial margin. So it’s perhaps unsurprising that 79 per cent of surveyed asset managers considered governance the most important of the ESG topics.

Environmental and social factors tend to be harder to weigh in terms of performance impact. And yet the ultimate beneficiaries for whom asset managers invest – individuals, pension funds and institutions – consider both to matter even more. In part, this perceptions gap could be down to differing time horizons.

Governance issues can come to the fore much more quickly and because environmental and social components of ESG are difficult to quantify and time, they are easier to ignore from a purely financial perspective – like the guy who only looks for his lost keys under the lamp post, because that’s where the light is.

Still, a carefully designed approach can help to shed some light on how these factors play out. For instance, serious environmental problems are often flagged up by a corporate culture that suggests a willingness to accept more minor infractions – BP’s Deepwater Horizon catastrophe was anticipated by the company’s poor environmental record elsewhere over a number of years.

Environmental costs aren’t just direct in the case of disasters. They can also disrupt supply chains. For example, some polluting motors are no longer produced. Companies that still use older versions and that fail to factor in these changes can end up with substantial development and maintenance costs. Elsewhere, Imperial College researchers found that climate change is pushing up borrowing costs in developing countries.

Social factors are even more a case of appraising corporate body language. But the risks are growing increasingly clear. Pressure is on companies to close gender pay gaps and boost wages for the lowest paid. For firms with thin margins and large minimum-wage workforces, this shift could ultimately have a significant impact on earnings. Companies with poor employee relations or ones that fail to tackle issues like discrimination not only face potentially expensive labour relations problems but risk damage to their brand value and reputation, especially as negative headlines are amplified by social media – as, for instance, Ryanair found to its cost. Others face opprobrium from how they’re perceived to treat users, like Facebook.

Ultimately, ESG investing only works if it helps to allocate capital to the companies that are likely to thrive over the long run. Robust governance, sensitivity and diligence in pursuing good environmental and social practices may be hard to quantify, and thus seem to be “soft” factors, but they are critical to how sustainable a company’s business model proves to be.

Frédéric Salmon, head of Credit, Pictet Asset Management

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