The basic premise of incorporating environmental, social, and governance (ESG) factors into an investment analysis is that an investment’s value can be affected (positively or negatively) by those factors. There are many reasons this makes sense, across all three pillars of E, S, and G, and volumes have been written on the topic. Just to set the stage, here are a few examples:
- climate change is causing costly natural disasters, severely damaging natural assets and reducing biodiversity in a way that qualifies as a mass extinction;
- there is a growing consumer preference for companies and brands with eco-friendly practices;
- workforce retention problems negatively affect productivity and drive up costs;
- diversity improves decision-making;
- insufficient governance leads to costly lawsuits and reputational damage, and so on.
It’s a long list (we recently came up with 25 examples, if you care to read more). Underlying all of this is the assumption that ESG issues can affect entire economies and an individual company’s profits, its ability to innovate and compete–in a nutshell, its long-term sustainability. Therefore, ESG factors should be reflected in stock prices. But is incorporating ESG factors into the investment process only relevant in equity markets. What about bonds?
ESG and traditional bonds
For now, let’s just talk about traditional bonds—corporate and sovereign debt—not “green” bonds, or “social” bonds, or “sustainability-linked” bonds. We’ll get to them later. A growing number of fixed income professionals agree that ESG is relevant in valuing corporate bonds. Unlike equities where there is upside to improving sustainability, in fixed income the main focus is usually on mitigating downside risk. Just as poor financial management increases corporate default risk, poor ESG practices can put pressure on revenues and profitability. Both types of “missteps” can cause credit spreads on that issuer’s bonds to widen in response to that increased risk.
Furthermore, Moody’s recently released an analysis showing that nine sectors that represent almost $1.9 trillion in rated debt that have “high” or “very high” exposure to a decline in natural capital, the assets in nature that keep the world’s ecosystems in balance. These sectors obviously include coal mining and oil and gas exploration that may have such a harmful impact on natural systems that it could have a material financial impact on these companies. They also include companies whose products and services are highly dependent on ecosystems, such as agriculture and tourism. Moody’s said its “environmental heat map” also identified another 24 industries with $9.6 trillion of outstanding debt that have a “moderate exposure” to natural-capital risks. Separately, Blackrock states that the financial materiality of different ESG pillars varies greatly across sectors.
Analytics firm Coalition Greenwich conducted a survey of 111 senior buy-side fixed-income investors and found that 90 percent believe incorporating ESG risks into bond analyses is important. But there is a gap between where survey participants believe the industry should be and its current state, as only about one-third of those surveyed have fully integrated ESG into their analyses. When asked what is preventing them from doing so, respondents identified data challenges as the biggest obstacle. This includes concerns about data quality, greenwashing, and inconsistent ratings from ESG ratings sources. Coalition Greenwich’s senior analyst Stephen Bruel noted, “If you don’t have reliable ESG data about an issuer or issuance, it’s harder to calculate what the negative consequences might be.”
Morgan Stanley also reports that investors are tilting toward ESG in the high-yield space, and more portfolios have specific environmental mandates, including targets for reducing C02 emissions. The energy sector, materials, metals and mining, and utilities together represent about 30 percent of the high-yield market but contribute more than 80 percent of carbon emissions. That is both a problem and an important opportunity for improvement, and investing in green bonds is a way to encourage positive change. The metals and mining sector is often shunned by investors as “dirty” from an ESG perspective, but decarbonization requires electrification, and that requires copper, which must be mined, which takes a great deal of water. Green bonds can help mining companies to improve their environmental impacts in terms of water use and pollution.
ESG and Emerging Market Sovereign Debt
A government’s ability to repay its debt depends on various factors, including political stability and the health of its economy. That, in turn, depends its natural resources and the productivity of its people, which depends on their access to food, healthcare, and education. We’ll stop there (otherwise, we risk going too far into the bottomless pit of macroeconomics), but we can already see that E, S, and G factors affect a country’s sovereign credit risk.
Many firms identify ESG indicators that they believe are important to a country’s economic progress and resilience and are therefore material in analyzing its sovereign debt. As one example, Morgan Stanley uses the following, which differ from what one would likely use to analyze ESG risks for companies, particularly in terms of Social and Governance: Environmental – Carbon Emissions, Climate Vulnerability, Forestry Conservation; Social – Life Expectancy & Health, Education, Living Standards; Governance – Voice & Accountability, Political Stability, Effective Government, Regulatory Quality, Rule of Law, Corruption, Violence/ Terrorism.
According to Blackrock, ESG explains “a meaningful share” of the variation in credit spreads across sovereign issuers in emerging markets. Issuers with strong ESG credentials tend to have lower credit spreads, and vice versa. Blackrock says its analysis indicates that ESG-related risks are being priced into the market for emerging market sovereign debt. Alliance-Bernstein notes that governance concerns are particularly important in evaluating sovereign investment.
In a separate category, investor interest in green, social, sustainability, and sustainability-linked bonds is growing:
- Green bonds: Capital raised is used for climate-related or other environmental projects;
- Social (or social impact) bonds: A public sector or governing authority uses capital raised to pay for social “goods” such as improved food security, affordable housing, access to essential services, etc. In many cases, social projects are aimed at target populations such as those living below the poverty line, the unemployed, and people with disabilities.
- Sustainability bonds: Issues whose proceeds are used to finance or re-finance a combination of green and social projects or activities.
- Sustainability-linked bonds: Issued by companies and governments, funds raised can be used for anything, including general corporate purposes but interest payments are linked to sustainability targets tied to UN Sustainable Development Goals (SDGs) or specific KPIs (the bond’s coupon rate will typically increase if target outcomes are not achieved).
Collectively known as “impact” or “labeled” bonds, capital raised via issuance of these securities is directed to specific projects focused on addressing sustainability issues. According to the Climate Bonds Initiative, issuance of green, social, sustainability and sustainability-linked bonds reached $1 trillion in 2021, more than 69 percent higher than 2020’s total of $606 billion, and almost triple the $326 billion issued in 2019.
Over the past couple of years the U.S. labeled bond market has grown considerably but still lags behind Europe. In 2021, roughly 27 percent of investment grade new issues and close to 20 percent of high-yield new issues in Europe were labeled. In contrast, in the U.S. only 6 percent of investment grade bonds issued in 2021 were labeled, and only 3 percent of high-yield issuance. This indicates a great potential for further expansion in the U.S. market. The World Bank reports that emerging market issuers issued US $182 billion in green, social, sustainability and sustainability-linked bonds in 2021, more than triple the amount issued in 2020. The following shows a breakdown of this issuance by category:
2021 Sustainable Bond Issuance – Distribution by Value
In summary, we think it is safe to say that investors now see that bonds and ESG go hand-in-hand. We hope this quick tour of the relationship between ESG and fixed income markets offers useful insights into why ESG does affect bonds, how this landscape is evolving, and the importance of having good data, and the right kind of data, in this space. Contact us to learn how OWL ESG can provide guidance in this area.