Sustainable investing and bond returns

Key findings of this report

In investigating the link between ESG and corporate bond performance, Barclays Research constructed broadly diversified portfolios tracking the Bloomberg Barclays US Investment-Grade Corporate Bond Index. They matched the index’s key characteristics (sector, quality, duration) but imposed either a positive or negative tilt to different ESG factors.

• Barclays research shows that ESG need not be an “equity-only” phenomenon and can be applied to credit markets without being detrimental to bondholders’ returns.
• The findings show that a positive ESG tilt resulted in a small but steady performance advantage.
• No evidence of a negative performance impact was found.
• ESG attributes did not significantly affect the price of corporate bonds. No evidence was found that the performance advantage was due to a change in relative valuation over the study period.
• When applying separate tilts to E, S and G scores, the positive effect was strongest for a positive tilt towards the Governance factor, and weakest for Social scores.
• Issuers with high Governance scores experienced lower incidence of downgrades by credit rating agencies.
• Broadly similar results were observed using ratings from the two ESG providers considered in this report despite the significant differences between their methodologies.


The road to sustainable returns

Sustainable investing, in which Environmental, Social, and Governance (ESG) issues are incorporated into the investment process, is increasingly gaining a foothold in mainstream financial markets. For some of the most committed investors, the knowledge that their funds are being invested to support their values is so important that they would accept a lower return on their investments. A much larger group would be happy to support these values, but only once they are convinced that there is limited negative return impact. Finally, if consideration of ESG principles can actually help to improve portfolio performance – as many adherents claim – then it would be hard to justify any resistance to their adoption. The relationship between ESG characteristics and performance is therefore of primary importance.

Focus on credit market
In the absence of much research into the impact of ESG on the credit markets, Barclays Research has conducted a new study to determine the nature of the relationship between bond performance and ESG. We focused on the credit markets for several reasons.

• First, an increasingly large number of bond investors is interested in ESG investing.
• Second, the relationship between sustainability and portfolio performance has been extensively researched in the equity market and much less so in credit.
• Third, credit investing is dominated by institutional investors, including pension funds, which are leading the trend for sustainable returns; bonds represent a substantial percentage of their assets.
• Finally, corporate bonds are complex: they combine exposure 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. To aid bond managers in evaluating the potential performance effect of integrating ESG data into their portfolio construction, we knew it was important to construct a study that carefully avoids any systematic risk exposures.


What this report covers

We begin with a short overview of what drives ESG investing and the rapid rise in its popularity over the last decade. Next, we offer a glossary of terms to help address the proliferation of buzzwords and acronyms that have been used in this field. We then investigate the impact that increasing ESG awareness has had on different groups of financial market participants, including asset owners, asset managers, corporate managers and regulators. Finally, we present a list of ten areas in which the industry has undergone significant changes in recent years, and discuss the implications of these trends for the future.

The second section addresses ESG ratings. Many market participants rely on independent providers of ESG scores and ratings in their investment decisions. In fact, we rely on them ourselves when we seek to quantify the performance impact of ESG-motivated investment decisions. We therefore try to understand them better: what exactly do the scores measure and how are they constructed? We describe the approaches followed by two major ESG providers – MSCI and Sustainalytics – and investigate the relationships between different metrics. How do these scores relate to more traditional credit ratings, or to corporate bond spreads? How stable are the scores over time? We investigate these questions in the context of the US investment-grade credit market.

Finally, we perform a detailed analysis of the relationship between ESG scores and corporate bond performance. We construct high-ESG and low-ESG bond portfolios carefully designed to track the index by controlling for the non-ESG factors known to affect bond returns. We find that the high-ESG portfolios have tended to outperform historically, and we try to understand why.


ESG is becoming mainstream

Responsible investing goes by many different names and definitions, but can broadly be described as expanding the objectives of an investment process beyond pure financial considerations to reflect investors’ values and beliefs that their holdings affect the community and broader eco-system.

In order to measure the sustainability of investments, a widely accepted set of metrics has evolved, known as environmental, social and governance (ESG) scores. In addition to the traditional objective of delivering financial returns, ESG investing enables investors to structure portfolios that are aligned with their values. While not new, responsible investing has gathered momentum and taken on broader significance in the past ten years. The United Nations, for example, supported the launch of six Principles for Responsible Investing in 2006 to incorporate sustainability into investment practice1. Collectively known as UN PRI, it has since then attracted nearly 1,500 signatories, collectively controlling over $60 trillion of assets under management.

The rise in responsible investing has followed the growth and increasing sophistication of large institutional investors such as pension plans, sovereign wealth funds, insurance companies and mutual fund managers. As these institutional asset owners are ultimately accountable to a large base of individual policyholders, they have in many cases found it necessary to align their investment processes with the priorities and values of their beneficiaries. These large investors have often been at the forefront of ESG innovations, insisting on high standards of corporate governance as well as on controlling potential negative impacts of corporate activities on society and the environment. In addition, laws and regulations may not ensure that corporate behaviour is always desirable from a broad societal perspective. In this context, ESG can be seen as an alternative to more regulation.

We are at a turning point where ESG investing is maturing and being formalised through ESG integration into decision-making processes, standardisation of ESG data, new benchmark indices, and broader pro-active engagement with issuers. The widespread adoption of ESG investing has come hand in hand with a subtle but critical change in emphasis. The early charge was led by ethically motivated investors clearly focused on environmental and social issues while most institutional investors looked on from the sidelines, concerned about the potential negative impact on portfolio returns.

The key to gaining traction was in reversing the perceived effect on performance. Not only is it no longer assumed that “doing the right thing” will place a drag on portfolio returns; rather, it is now seen as prudent to avoid investing in companies that have a detrimental impact on the world, because their business practices may not be allowed to remain unchanged. ESG ratings providers thus emphasise that their ratings measure the risks of negative events stemming from poor behaviour in the Environmental, Social and Governance spheres; and the jargon used to describe the industry (see glossary on p. 8-10) has evolved towards terms that have positive connotations regarding performance.


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