It’s been 12 years since the United Nations published its Principles for Responsible Investment (PRI) and, judging by the growth in signatories since 2006, the investment management industry largely accepts the benefits of integrating non-financial factors into investment processes.
There’s less consensus over what is meant by responsible investment – the term can mean different things to different people – and crucially over whether there’s a financial cost to it.
Such ambiguities have raised important questions for investors and issuers alike – even for those sold on the importance of what we now call environmental, social and governance (ESG) considerations.
If we’re to accept that ESG factors will play a permanent role in the investment process, they reasonably ask, how much importance should they be given, how should they be measured and by whom?
Crucially, they want to know, do ESG factors have an impact on borrowing costs and, if so, what are the implications for the fixed income market?
The PRI defines responsible investment as “an approach to investing that aims to incorporate ESG factors into investment decisions, to better manage risk and generate sustainable, long-term returns”.
It’s reasonable to ask whether ESG factors have a distinct influence on bond prices. The notion of sustainability was reinforced with the publication of the UN Sustainable Development Goals and was described by Ban Ki-Moon in 2015 as “ensuring prosperity and environmental protection without compromising the ability of future generations to meet their needs”.
In the absence of an official definition, the PRI’s fixed income investor guide suggests a key application for ESG information is to inform analysis of issuer creditworthiness, adding: “ESG issues, such as corruption or climate change, are potential risks to macro factors that may affect an issuer’s ability to repay its debt.”
The fundamental elements of issuer analysis remain the same for all types of issuers, it concludes.
An ESG factor is a non-financial measure that we consider may be likely to influence significantly an issuer’s ability and willingness to service its financial obligations. Crucially, we believe the assessment should be ours, but the measurement should not be.
A third-party measure means that clients are able, independently, to monitor the investment decisions made on their behalf.
Although there are many suppliers of ESG data and their definitions of ESG factors and interpretations differ, investment managers will increasingly incorporate the measures of one or more of these suppliers into their investment process.
Naturally, individual investment managers will weigh the significance of ESG factors differently from the third-party assessment and this will inform their views on the relative creditworthiness of an issuer.
However, they will incorporate other factors into their investment views, such as the currency, maturity, credit quality and sector of the bonds, as well as more traditional aspects of credit analysis such as the issuer’s corporate structure, business strategy and competitive position.
It’s reasonable to ask whether ESG factors have a distinct influence on bond prices.
That is, can we see an effect after taking into account the contribution that other, more traditional credit factors make to bond spreads?
We looked at the overall ESG scores provided by ratings agency MSCI and sought to assess their influence on the spreads of bonds from a cohort of issuers.
In an admittedly limited exercise – we considered only the overall MSCI score and not the subsidiary indicators they also publish – we nevertheless expected that, if ESG factors were priced, we’d see that the ESG rating influences spread: a higher score leading to lower spreads, all else being equal.
Clearly this leaves open the question of whether the extent of any influence on spreads is adequate, but that is beyond the scope of this exercise.
The factors that we expected to be important in determining spreads were the maturity of the bond, the credit rating, the sector, the currency of the bond and whether the issuer was a domestic or foreign issuer.
To produce a balanced sample, we chose a cohort of investment grade, corporate and supranational issuers that have bonds in both euros and US dollars.
We can conclude from this that it is valuable to use measures of ESG factors provided by a third party and we find evidence that they are modestly priced.There were 4,785 bonds in this cohort on 13 February 2018, which we used as the valuation date for this exercise. We were seeking to explain the influence of each of the factors on the spreads of the bonds.
The data presented a technical difficulty. As spreads are typically greater than zero, the spread data is not normally distributed, which means that ordinary least squares regression results can be biased.
We therefore used quantile regression, which is robust to these effects.
Ordinary least squares regression estimates the mean effect of the explanatory variables and so is influenced by all the data in the sample. Quantile regression, on the other hand, estimates the effect at the specified quantile of the distribution and is most strongly influenced by the data at that point of the distribution.
We plotted the estimated effect of the overall ESG score for the quantile regression at the 10 per cent, 25 per cent, 50 per cent, 75 per cent and 90 per cent quantiles, as well as the mean response from ordinary least squares.
The mean response says that an issuer with the poorest overall ESG rating pays 20 basis points (0.2 percentage points) more than a comparable bond from an issuer with the best overall ESG score.
This number is small but not negligible – it is of the same scale as the difference in spread of AA- and A+ credits.
We were able to see the skewed nature of the response in an upward sloping of the response with increasing quantile.
However, the most telling feature of the resultant graph was that the mean response was greater than the response at all the measured quantiles.
This suggests the average response is driven by the responses in the tail of the distribution.
Our interpretation of this result is that ESG factor exposures are only priced after the event, i.e. only after something ‘bad’ has happened do investors demand a significant risk premium for poor ESG risks.
We can conclude from this that it is valuable to use measures of ESG factors provided by a third party and we find evidence that they are modestly priced.
Investors should make their own judgement of whether significant ESG factor risks are discounted by the market.
There is evidence that issuers with poor ESG scores have modestly higher borrowing costs, but the distribution of responses is highly skewed.
This suggests to us that ESG factor exposures are only priced after an ‘event’ and, therefore, there is value to our clients in incorporating consideration of ESG factors into issuer selection decisions.
Guy Cameron is chief investment officer at Cameron Hume
