This report by Barclays aims to find further evidence of the positive effects of environmental, social and governance (ESG) investing in the credit markets. Many investors are weighing the merits of incorporating ESG criteria into practice, asking the question, how does this affect performance? The report aims to address this question by taking a data driven approach to looking into the effect of ESG, not only on US investment-grade (IG) corporate bonds, but also their euro counterparts and US high-yield (HY) bonds. Data is sourced from Bloomberg Barclays Bond Indices for bond characteristics and returns, MSCI ESG Research and Sustainalytics for ESG scores.

Some key findings include:

• Tilting a credit portfolio in favour of high-ESG bonds, while keeping all other risk characteristics unchanged, tends to lead to higher performance in all three markets considered.
• Environment has the strongest effects on ESG scores over the last 2 years in the US and 9 years in the EU.
• The link between E, S & G scores and performance varies across sectors.

Before analysing the data and making the investment case, the report discusses key characteristics of ESG scores and the effect of ESG on bond valuation. Examining characteristics allows Barclays to ask questions around what these scores represent, how they are calculated, and how stable they have been over time. Furthermore, how a naïve ESG bias can induce unwanted risk exposures in a portfolio.

Some key characteristics discussed are:

• The complexity of ESG scoring and how they vary across providers.
• ESG scores from different providers do not measure exactly the same thing.
• An ESG tilt may create bias in a portfolio.

When looking at the effect of ESG on bond valuation the report examines the extent to which an ESG “premium” has the potential to make corporate bonds more expensive. Barclays does this by looking at the effect of ESG on spread; the incremental yield over comparable government bonds. Barclays use the difference in spread between high- and low-ESG bonds  to estimate the ESG spread premium. Here the report finds that while ESG spread premiums fluctuate, there has been no downward trend in the US or European markets.

Analysing the effect of ESG on performance, the report compares bond portfolios with high- and low-ESG scores to measure their relative performance. Results from both ESG score providers show that high-ESG bond portfolios, in both US and Euro IG markets, continue to perform better than low-ESG ones. This confirms previous research that an ESG tilt has a positive impact on performance. The report then goes into breaking down ESG performance by industry to confirm if an ESG tilt has a positive return contribution across all sectors. Results are mixed.

Looking at US high-yield bond markets, Barclays uses a similar methodology to its previous analysis, making sure that all risk factors are equal. There are different challenges in HY to IG markets due to a higher risk of default and increased price volatility. Overall their findings on HY bonds show that high-ESG HY portfolios mostly, but not always, outperform the low-ESG ones.

In conclusion, this report has strengthened Barclay’s previous findings back in 2016, showing evidence that ESG has a positive effect on corporate bond performance across both the euro and US markets.

1. Investor interest in responsible investing is gaining momentum, which is strengthening the need for objective, quantitative analysis of the effect of ESG on portfolio performance.
2. This follow up investigation has confirmed Barclay's findings in 2016. Results show that tilting a bond portfolio systematically to issuers with better ESG ratings has been beneficial to performance across US and euro-denominated IG bond markets and US HY bond markets.
3. While tilting a bond portfolio to issuers with better ESG ratings can lead to better performance, a strategy that systematically favours high-ESG bonds without controlling for portfolio risk characteristics can easily underperform, simply because of its systematic bias towards higher-quality, lower-spread issuers.
4. Although the ESG spread premium has fluctuated, a downward trend has not been observed in the US or Europe markets. In fact, it has been broadly stable in Europe and has increased in the US. So any outperformance of high- over low-ESG bonds cannot be explained by a systematic richening of high-ESG bonds over the period considered.
5. When comparing the outperformance of high-ESG portfolios over low-ESG ones, the best single-pillar results come from governance for the US IG 9-year results, up to 2018. But environment has provided the strongest effect from 2016 to 2018. For Europe over the 9-year period, the component most closely related to outperformance has been environment.
6. When comparing the outperformance of high-ESG portfolios over low-ESG across sectors, the strength of E, S and G scores is varied. Governance is important in the banking sector, while environment is significant in most others.
7. Markets price ESG attributes differently to each other. This can be seen in the European and US markets where high-ESG bonds trade at persistently tighter spreads than low-ESG peers in Europe, but not in the US. European issuers also tend to have higher ESG ratings than US issuers. 
   
8. High-yield markets pose different challenges than investment-grade markets as many issuers are private companies with fewer ESG ratings. While this may make portfolio diversification more challenging, it is even more important in these markets as risk of default is higher and prices are more volatile.
9. Understanding the dynamics of ESG ratings is important to bond portfolio managers because systematically favouring high-ESG bonds might require incremental portfolio turnover and therefore entail high transaction costs if the ratings change often. At the same time, one would expect some ESG scores to change over time for a variety of reasons, including the effects of management decisions to mitigate ESG risk.
10. Even though this study has strengthened the investment case in relation to the positive effects of ESG factors on credit portfolio performance, there are still questions to be answered. For example, if there has been no systematic change in the ESG valuation premium, what drives the outperformance of high-ESG portfolios?