Responsible investing has gathered momentum across the world in the past decade as investors look for financial returns while helping to achieve a positive impact on the world around them.
In the first report in Barclays’ Impact Series, our study shows the positive effect that environmental, social and governance investing can have on bond portfolio performance.
Does the incorporation of environmental, social and governance (ESG) criteria in the investment process improve the financial performance of a bond portfolio or hurt it?
Barclays Quantitative Portfolio Strategy Research team recently investigated the relationship between ESG investing and performance in the US corporate bond markets. The highlights of the findings were:
In a world where concerns over climate change, pollution and issues of sustainability are ever more pressing, socially responsible investing has become an important consideration for a growing number of individuals and institutions.
Source: UN PRI
Different investors have different appetite for ESG. For some of the most committed, knowing that the funds in which they invest will help make the world a better place is so important that they are willing to accept a lower return on their investments. A much larger group would be happy to support these values if they could be convinced that their commitment would not result in underperformance.
Different investors have different appetite for ESG
If the sustainable investing tilt can actually help to improve portfolio performance, it would be hard to justify not adopting it. The relationship between ESG characteristics and performance is therefore of primary importance.
Financial data, such as accounting statements, alone are no longer regarded as sufficient to measure the health and strength of a company. It is also necessary to consider non-financial drivers of business success.
These can range from environmental (E) issues such as pollution, global warming and energy conservation, to social (S) issues such as work practice considerations and governance (G) issues such as corporate management.
The three dimensions covered by ESG can help make the broad aspiration to be “responsible” more tangible and measurable against a set of objective metrics. Investors and asset managers both rely on independent providers of ESG scores and ratings in their investment decisions. In our study, we used ESG scores from two major providers: MSCI and Sustainalytics.
The investment objective of “responsibility” has different implications for asset owners and asset managers. Asset owners want to make the world a better place by allocating resources to responsible companies while maintaining financial performance.
Asset managers acting on behalf of those asset owners want to be seen as ESG compliant in order to attract ESG mandates and assets, but also need to deliver financial performance to retain those assets.
Source: Barclays Research, Barclays survey of large fixed income asset managers (2016)
Responsible investors often hope to improve sustainability by engaging with corporates through, for example, proxy voting in shareholder meetings, allocating capital to more virtuous companies and lobbying for changes in regulations and reporting standards.
As ESG factors are expected to play out over a long horizon, responsible investing can also be an encouragement for the managers of public corporations to take a longer-term approach to value creation. This can be a counterweight to the pressure for delivering short-term financial performance if it conflicts with a company’s long-term sustainability.
In our analysis of the link between ESG investing and asset performance, Barclays Research focused on the US credit market – rather than equities - for various reasons:
The details of how an ESG policy is implemented in a portfolio may have a direct impact on its performance.
There is a key distinction between an ESG approach based on negative screening by industry and one based on relative comparisons of the firms in each industry.
For example, an investor using a negative screen may choose to exclude coal mining companies from their investment universe. Another investor may use ESG ratings to rank coal mining companies, and choose to invest in the ones that have the best overall ranking within the sector. In the first case, in a year in which coal mining companies outperform the market, the investment portfolio may lag a broad market index.
In the second approach, the portfolio is neutral with regard to the systematic sector exposure, but favours those companies with better ESG policies – i.e., those that do less harm to the environment, treat their workers better, and are better managed.
In our study, we constructed diversified portfolios designed to track the US Investment Grade Corporate Bond Index and imposed either a positive or negative tilt to different ESG factors. We found that:
Source: Sustainalytics: Barclays Research
'Sustainalytics' Governance pillar measures governance of sustainability issues. The firm has a separate Corporate Governance rating that is not represented in this study
Source: MSCI ESG, Barclays Research
The message conveyed by this analysis is that incorporating an ESG tilt in an investment-grade credit portfolio is not detrimental to returns, but can be beneficial – especially where the Governance tilt is concerned. Governance may indeed be a reflection of management quality and, over a long horizon, can benefit bondholders. (Note that both ESG score providers have updated their methodologies over the period of our study. When measured over the most recent history the performance results based on their respective scores are in even closer agreement).
We also wanted to establish whether there is a relationship between credit rating, which measures the financial strength of a company, and ESG factors.
In grouping the bonds in the Bloomberg Barclays US Corporate investment-grade index into buckets of low, medium and high ESG scores, we found that:
From these results, it is clear that investors should be careful when integrating ESG data in portfolio construction to avoid unintentional biases in allocation and risk profile. Just overweighting better ESG companies can easily result in lower yields and consequently lower returns.
Looking at whether ESG scores relate to future changes in credit ratings, we found that bonds with high Governance scores (using MSCI data) experienced fewer downgrades than those with low G scores.
Looking at E, S and G factors individually, the credit rating differential between top and bottom tiers was more pronounced for the Environment pillar and almost absent in Governance. This could mean that issuers with higher credit quality (stronger balance sheets) are better able to comply with environmental constraints than those with lower credit quality.
Source: MSCI ESG Research, Barclays Research
Get a snapshot of what ESG is and how it is changing the investment ecosystem
Read the full report, providing in-depth analysis from our study on ‘Sustainable investing and bond returns’
Does ESG impact potential investment performance?
Our Co-Head of Research discusses the report's analysis on CNBC Worldwide Exchange