How impact investors can create system-level change through long-term fixed income investments
While most environmental, social and governance (ESG) investment options focus on equities rather than bonds,1 we believe that ESG analysis is a natural complement to the goals of fixed income investors and the investment process for investment grade (IG) bonds.
Equity investment is typically aimed more at total return or wealth-building (seeking upside potential), while fixed income investment typically centers more around protecting against downside risks. Given that ESG analysis can offer additive insight to the underlying risks of an investment, we believe it is a strong support to bondholders’ objectives of risk mitigation and long-term liability management (see Assessing Performance and Objectives in a New Bond Environment). In addition, ESG is well-aligned with the inherent properties of fixed income securities, which can have a long-term horizon depending on the maturity of the bonds held.
Historical bond pricing and credit trends give insight into how ESG can be a solid ally in prudent credit selection.
- Fixed Income as a Counterbalance to Riskier Securities
One of the main roles of IG fixed income for investors – acting as a counterbalance to equities and other riskier assets – lends itself to ESG analysis. While traditional financial statements are valuable, they do not always tell the full credit story of a company or municipality. By analyzing extrafinancial factors as well, we believe investors are positioned to better understand corporate and municipal borrowers and mitigate risks.
For example, California recently announced that SB100, a new clean-energy bill, has been signed into law. The state’s electricity must be emissions-free by 2045. This could galvanize other states to follow, and likewise jump to strict emissions targets. Markets could eventually begin to look at corporate greenhouse gas (GHG) emissions with more scrutiny than in the past; that is, the market could begin to price GHG risk higher, leading to bond price declines and increased credit risk for some issuers. In this case, ESG could help to home in on potential risks that are underpriced in the market.
- Fixed Income as a Long-Term Investment
Fixed income investors typically have a longer-term horizon, and we note that some borrowers issue 30-year or even 100-year bonds. Most IG bond investors are interested in capital preservation and steady, reliable income over the long term (see The Short-termism Debate Heats Up). The analysis of ESG factors helps to identify issues that could portend long-term credit stress.
As examples, risks such as high local unemployment, educational inequality in a community or a lack of independent board membership in a corporation could cause minor disruption to credit spreads or ratings in the short term and could significantly hurt long-term fundamentals. Also signaling a long-term horizon, we note that big lenders such as Citigroup have developed risk-management frameworks that incorporate material environmental and social risks for project-related finance.2
- IG Credit Deterioration Is Typically Slow …
IG corporate and municipal annual default rates are near zero, and the credit risks for IG bonds can take many years to manifest. For example, among all global corporate defaults in 2017 that were originally rated IG, the average time between the first rating and the default was more than 28 years, per S&P (only five of the 95 corporate defaults in 2017 were originally rated IG).3 This “slow burn” of high-quality credit deterioration lends itself to analysis that is focused on long-term, sustainable credit performance. Furthermore, ESG analysis often reveals management priorities; in our opinion, a management team that prioritizes ESG risks and takes advantage of sustainability to drive revenue growth is better positioned over the long term.
- … but Current IG Trends Require Diligence
While a focus on long-term trends is paramount for bondholders, we note that some current trends in corporate and municipal markets may accelerate deterioration for some credits, which requires investors to closely analyze issuers and avoid becoming complacent. By shining a light on extrafinancial issues for borrowers, ESG analysis can help investors be more discerning in their credit selection.
For municipals, the “rules” of credit quality have been challenged by events in recent years. As Moody’s notes, “The once-comfortable aphorism that ‘munis don’t default’ is no longer credible.”4 Just months ago, Illinois was on the verge of being downgraded below IG, which would have been a first for a U.S. state. Declining willingness-to-pay in the market (see Thoughts on Modern Populism and the Muni Market), the questions of seniority and repayment surrounding Puerto Rico bonds, and the growing pension debt across some U.S. states have increased the importance of in-depth analysis.
On the corporate side, record-high debt leverage5 continues to strain credit fundamentals (see Corporate Bond Market Outlook Q2 2018), and if U.S. economic growth slows or a recession occurs leverage could go even higher. Also, corporations have been aggressively performing share buybacks and M&A, which has raised event risk.
- High-Impact, Low-Probability Events
IG bond performance has an inherent asymmetry; upside potential from capital gains is typically limited, while downside risk in the event of default is significant. However, as mentioned, IG defaults are very “low probability,” as the IG default rate for municipals and corporates is near zero.6 Ratings risk is also a concern, but higher-rated credits have historically exhibited strong ratings stability, per S&P. For example, cumulatively from 1981-2017, 87 percent of credits rated AA in one year remained AA the following year.
By helping investors to uncover underpriced risks of borrowers, we think ESG analysis is a natural match for the “high-impact, low-probability” types of events that could lead to a sharp decline in the credit quality of a security. These events could include corporate governance scandals, major environmental disasters or burdensome legal fees.
The financial crisis, negative credit outcomes related to poor corporate governance and short-termism, have helped prompt growing demand for strategies that consider the relevance of extrafinancial factors. Ultimately, we continue to believe that integrating ESG analysis with traditional financial analysis can lead to improved long-term risk-adjusted returns in fixed income.
 Of nearly 1900 ESG funds tracked by Bloomberg, 62 percent invest in equities versus only 15 percent that invest in fixed income. On an asset basis, bonds make up only 3 percent of the $491 billion invested in ESG funds. Source: Chasan, Emily. “How to Build a Sustainable Bond Portfolio.” Bloomberg, August 29, 2018.
 Citi Environmental and Social Policy Framework, April 2018.
 S&P’s database begins with all active ratings as of December 31, 1980, and two of these defaulters have this as their first ratings date. If S&P were to use the actual first ratings date, the time-to-default would be even longer. Cumulatively, from 1980 to 2017, only 0.3 percent of credits originally rated AAA defaulted; 1.1 percent of AAs; 3.7 percent of As; and 7.7 percent of BBBs.
 Moody’s Investors Service, June 2017.
 JP Morgan report, High Grade Credit Fundamentals 2Q18, August 24, 2018. Ex-commodities, Leverage is at its highest level post crisis.
 Diane Vazza and Nick W. Kraemer, “Default, Transition, and Recovery: 2017 Annual Global Corporate Default Study and Rating Transitions,” Standard & Poor’s, as of April 5, 2018. Lawrence Witte, Zev Gurwitz and Nicholas Castro, “Default, Transition, and Recovery: 2017 Annual U.S. Public Finance Default Study And Rating Transitions,” Standard & Poor’s, as of May 8, 2018.
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