Environmental, social and governance (ESG) factors are increasingly integrated in investment allocation decisions. Popular methods of incorporating ESG include positive/negative screening of companies, integrating ESG metrics in risk and return analyses, and corporate engagement. While metrics related to governance measure management quality, environment and social metrics capture risks and opportunities often specific to particular industries or business activities. 

The trend of ESG investing has gained traction in the last few years due the reversal of its perceived negative effect on performance. Furthermore, the move from only excluding investment in controversial sectors toward investments that favour stronger ESG credentials has allowed for more objective and proactive sector-specific risk management strategies.

ESG investing is increasingly seen as a systematically integrated process rather than a specialist activity. In response to ESG disclosure related regulation, thematic funds (including ETFs) and ESG benchmarks have been launched. Although there is no standardisation on ESG reporting, many data providers (e.g. MSCI and Sustainalytics) have developed their own methodologies for rating companies on their ESG efforts. The majority of asset managers rely on third-party ESG ratings, in the same way they do on credit ratings. 

The Barclays Research team has conducted this research study to assess the impact of incorporation of third-party ESG ratings on credit portfolio performance. 

First, the team grouped corporate bonds included in the Bloomberg Barclays US Investment-Grade Bond Index that had been ESG rated by MSCI and Sustainalytics, into high, medium  and low ESG categories. A comparison across the three categories revealed that the difference in rating between high and low ESG bonds corresponded to a one-notch change in credit rating (i.e. from AAA to AA).

The average spread between high-ESG and low-ESG bonds was 38 basis points (MSCI) and 35 basis points (Sustainalytics) respectively. Repeating this analysis for individual environment (E), social (S) and governance (G) factors, demonstrated similar results. The effect persisted over time (August 2009 to April 2016) and was more pronounced for the G factor and less for the E factor. 

Second, the research team designed and examined well-diversified portfolios that differed significantly in ESG rating, but had nearly identical risk profiles. The portfolios were designed to track the Bloomberg Barclays US Investment-Grade Bond Index, and were rebalanced monthly to track the benchmark along multiple risk dimensions. The difference in ESG performance was labelled the ESG factor which demonstrated the contribution associated with systematically favouring high-ESG bonds over low-ESG bonds. Assessing the difference between high and low ESG portfolios when paired, the team found that most pairs delivered positive returns, indicating a positive return premium for the ESG factor in corporate bond markets.

In addition, the governance factor had the strongest link with performance, and the social factor the weakest. A cumulative outperformance of almost 2% was found over the duration of the study. Furthermore, the team found that ESG attributes did not significantly affect the price of the corporate bonds. This showed that the performance advantage was not due to a change in valuation over the study period.

1. This study provides bond investors with statistical proof that ESG can be integrated in credit markets without compromising returns, and in fact, sustainable investing has been beneficial to bond returns.
2. By comparing high-ESG and low-ESG corporate bond portfolios with nearly identical risk profiles, the study demonstrates that a positive ESG tilt creates a small but steady performance advantage.
   
3. There was no evidence of negative performance impact resulting from a positive ESG tilt in the corporate bond portfolios designed and examined for the study.
   
4. When applying tilts to environment (E), social (S) and governance (G) factors in isolation, the study found that the performance advantage was strongest for a positive tilt toward the G factor, and weakest for the S factor.
   
5. The study found broadly similar results using ratings from MSCI and Sustainalytics despite the significant differences between their methodologies.
6. 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.