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Audience

Why ESG matters more than ever in high yield debt

10/06/2020

The global market sell-off in early 2020 left few assets unscathed. Corporate bonds offering higher prospective returns but towards the riskier end of the investment spectrum – also known as high yield bonds – were no exception. Investors sought safer assets like cash, as the coronavirus started to shut down the global economy.

The pandemic has coincided with an increase in the number of investors looking beyond traditional financial considerations to also consider an investment’s wider impact on society. As we emerge from this crisis, I anticipate that this trend will only gain momentum.

The rise of responsible bond investing

Changing attitudes have helped to drive an increase in the number of investment strategies that consider environmental, social and governance (ESG) factors in the past few years.

Most strategies have tended to focus on investing in debt from ‘investment grade’ issuers, in other words bonds issued by companies that are considered relatively more credit-worthy, rather than investing in ‘high yield’ bonds that are issued by companies considered relatively less credit-worthy. They are so-called, of course, because they typically offer higher yields – being the prospective annual income from a bond as a proportion of its price – than investment grade bonds.

Although the high yield bond market contains a relatively small number of companies that display the strongest of ESG credentials, I firmly believe that ESG factors can play an important role in high yield investing. After all, thorough consideration of non-financial metrics of performance should ultimately lead to a better informed investment decision.

Beyond basic exclusions

A good starting point is to remove from consideration the bonds of companies that do not meet basic standards on human rights, labour, environment protection and anti-corruption, as well as those that operate in certain sectors. Companies that derive most of their revenue from tobacco or alcohol would typically be excluded from consideration by ESG approaches, for instance.

I believe we should go further, though, and filter companies according to their overall ESG credentials. By integrating analysis of how companies perform against environmental, societal and governance metrics, we can screen out the laggards.

Importantly, companies can be assessed on an industry-adjusted basis, taking into account the key issues that are relevant for that sector and by comparison to the standards and performance of their industry peers. I believe this can help investors maintain a large and diverse selection of issuing companies, while achieving favourable ESG outcomes.

The performance trade-off myth

One of the lingering contentions surrounding ESG investing is that there must be an inevitable trade-off with the financial returns you can achieve. Yet there is a mounting body of evidence dispelling this myth.

Recent analysis of the US high yield market by Barclays found that portfolios with high ESG scores, based on MSCI and Sustainalytics company scores, outperformed those with low ESG scores between 2012 and 2018. The analysis found that outperformance was driven by governance factors, in particular.

This should come as no surprise. After all, good governance should lower the risks of corporate failure which, for bond investors, is always bad news. This is why many active bond investors will engage with company management on issues where they have leverage, either because of the size of their investment or alongside major shareholders.

As always, note that past performance is not a guide to future performance.

Why it matters now, more than ever

As well as encouraging better behaviour, engagement with companies helps investors better understand the non-financial risks and opportunities they face. In times like these, when there is a heightened risk of corporate collapse, this can be an obvious advantage – especially so in the high yield market, where companies are often under-researched and the risk of issuers defaulting is naturally higher.

Although the market has rallied since the sharp sell-off of March, high yield bond prices had only partially recovered two months later. Falling prices have pushed up yields on high yield bonds to levels not seen since the global financial crisis, just over a decade ago. Looking at the high yield market as a whole, prices seem to reflect an expectation of the worst-case scenario resulting from the ongoing pandemic.

Defaults, when companies fail to either keep up with regular interest payments or repay the principal amount borrowed at the end of the loan’s term, will no doubt rise. But I do not think they will reach record levels, especially with the degree of support from governments and central banks to help the global economy avert a protracted recession.

There will be more bad news to come, but I believe the indiscriminate sell-off in high yield bond markets has presented opportunities to invest in the debt of companies with positive ESG credentials. For investors with a long-term outlook, companies with good governance that limit harm to society and the environment should be less likely to fall foul of regulatory and normative changes that could be accelerated by this pandemic.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

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The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.
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