Sustainability considerations are affecting debt markets more for many reasons, including desire for resilience in portfolios, climate and other environmental, social and governance (ESG) risk exposures, and regulator push. Debt instruments are catching up with equities in this regard, and more tools and insights are arising to help address their unique needs, such as longer-term horizons and focus on mitigating downside risk. BlackRock examine four practical areas emerging in ESG fixed income.

Sustainable Building Blocks

Equity markets have historically led when it comes to ESG investing, however, fixed income is catching up as investors pursue strategies to improve portfolio sustainability. The article outlines how applying ESG to fixed income requires a nuanced approach different to equities, due to the sectors unique attributes including asymmetric risk, special approach needed for sovereigns, emphasis on use of proceeds, and fewer options for engagement.

BlackRock highlight how new ESG bond indexes are providing a low-cost strategy for investors to boost their sustainability ratings. These ESG indexes can be approached in different ways: negative screens, targeting strong ESG performers, and maximising a portfolio’s weighted-average ESG score while closely tracking the parent index. BlackRock suggests ESG may serve as a proxy for quality in fixed income (like equities) and how given new tools, longer track records of provenance, and more, ESG investing in fixed income is no longer niche.

Sovereign Sustainability

BlackRock propose a method of evaluating sovereign sustainability. They use metrics from the World Bank’s ESG Data Portal to examine government performance on ESG issues, determined in line with the UN Sustainable Development Goals. They use ‘text-mining’ of big-data to measure the forward-looking intent across media outlets of governments in their evaluation. BlackRock suggest their method can be applied to provide insights into credit spreads across emerging market (EM) government issuers. One key conclusion made: credit spreads are negatively correlated with ESG scores.

Materiality Matrix

What matters in ESG in credit? BlackRock propose a materiality matrix, building on work from the Sustainability Accounting Standards Board (SASB), to add a quantitative lens and measure the connection between exposure to given sustainable properties and returns or risk.

BlackRock applied their analytics and tools to consider the financial materiality of different ESG pillars across sectors: their Sustainability Framework, which comprises 6 categories:

• Environmental: carbon transmission and natural resource management
• Social: board quality and corporate culture and management
• Governance: external and internal stakeholder management

… across 11 sectors, and this threw out two key sector highlights: Financials hold a meaningful link to environmental categories, suggesting investors are considering banks’ loan book exposure to fossil fuels. Utilities are also highlighted as being materially affected by corporate governance.

BlackRock suggest matrixes such as these could assist investors in delivering a financial edge in credit markets and driving engagement with companies.

Portfolio Construction

BlackRock demonstrate how adding fixed income ESG exposures to a diversified multi-asset portfolio can meaningfully increase the portfolio’s ESG impact and not meaningfully impact the diversification properties of the portfolio, without sacrificing return objectives.

This, they assert, as providing further evidence of this being a ‘why not?’ moment in sustainable investing.

1. The green bond market is maturing. According to the International Monetary Fund (IMF), outstanding issuance of green bonds hit US$590 billion in August 2020 - almost eight times the size of the market in 2015.
2. Credit spreads are negatively correlated with ESG scores. Issuers with poor ESG characteristics must compensate investors with higher yields. However, this relationship is not perfect as the paths of EM sovereign spreads and ESG scopes can decouple during sharp sell-off periods.
3. ESG could potentially serve as a proxy for quality in fixed income. Blackrock studied the European credit universe and found the top quintile of ESG performances outperformed the bottom quintile by approximately 50 bps cumulatively, despite its lower average yield. Furthermore, when examining the JESG EMBI Global Diversified Index against the JPMorgan Global Diversified Index, the ESG index achieved a return of 5.7% versus 5.6%, and volatility of 4.2% versus 4.4%. However, this ‘quality bias’ could mean that ESG exposure may underperform in ‘risk-on’ periods where lower-quality segments lead performance.
4. BlackRock’s early evidence suggests that it is possible to have an uplift in key ESG metrics using ESG bond indexes, such as carbon intensity, while adhering closely to standard index benchmarks (e.g. duration and yield) without sacrificing risk/return objectives. This is possible as macro factors such as interest rates make up the bulk of total risk in fixed income. BlackRock generated an uplift of 50% in a hypothetical portfolio’s weighted-average ESG score with a tracing error of 5 basis points.
5. Moody’s September 2018 analysis found that 11 sectors with $2.2trillion in rated debt were at risk of being downgraded due to environmental risks. Sectors such as the coal sector, electric utilities, auto makers, oil and gas, and commodity chemicals face the largest threat on a three-to-five-year horizon.
6. The data on ESG bonds is becoming more available: MSCI’s ESG data covered 93% of the issuers in the Bloomberg Barclay’s U.S. Credit Index in 2018, versus 75% five years earlier.
7. Markets have been giving weight to sustainability factors in their pricing of emerging market debt for at least the past five years. This is partly due to credit agency ratings currently factoring in G metrics (good governance and willing to pay) into their ratings, which are not reflected in traditional economic data.
8. 40 major U.S. dollar and euro green bond issuers were studied and there was no material pricing difference. There was no difference in credit risk, liquidity and bid-offer spreads. This suggests that green bonds are no longer a niche strategy for impact investors.
9. Poor ESG performers tend to pay a higher market premium to issue debt, which Blackrock argue may increase over time as regulatory pressures lead issuers to pay greater attention to sustainability.
10. BlackRock pose that duration-weighted ESG scores can be a solution when comparing the ESG profiles of two sustainable funds. The current approach uses market-value weighted averages of their ESG scores, but this potentially overlooks the bonds maturity date, and long-term bonds carry greater risk than short-term bonds.