ESG Considerations for Fixed Income – Credit Strategies
June 30, 2021
One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.
Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.
Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked [1].
In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.
Introduction
In this thought-leadership piece, we provide the reader with an overview of credit strategies for fixed income investors and how these strategies are linked to ESG. We begin by discussing risk considerations in investment-grade and high-yield corporate bond portfolios including the credit spread measures used in portfolio construction. We then turn our attention to top-down and bottom-up credit strategies before moving onto an overview of liquidity risk, tail risk, and international credit risk. We conclude with a discussion on how an ESG investment lens can be applied to credit strategy analysis.
Risk Considerations in Investment-Grade and High-Yield Corporate Bond Portfolios
Fixed income investment managers need to consider both credit risk and spread risk in their investments. Credit risk is a function of default risk and the percentage of loss if a credit default occurs. A bond’s credit spread is the difference between a high-yield bond and the yield on a government bond which is considered to have no credit risk. Spread risk is the risk that a bond will underperform as credit spreads widen. Spread widening is measured with spread duration where the change in relative value is the product of the spread duration and the change in spread. In general, investment grade bonds are more impacted by interest rate risk, spread risk, and credit migration risk. High yield bonds on the other hand are more impacted by credit risk. There is a negative correlation between the credit spread and the risk-free rate. When central bank rates are restrictive the economy is typically strong and credit spreads are tight. Under these conditions, high yield bonds will behave much like investment grade bonds. However, high yield bonds come with liquidity risk. The market for high yield bonds is smaller than the market for investment grade bonds. High yield bonds also typically have a higher bid-ask spread which is driven, in part, by regulatory requirements that prevent dealers from holding too many bonds.
Credit spreads can be measured in several ways. The benchmark spread is perhaps the most common. It is the difference between a high yield bond and a government bond. The G-spread is like the benchmark spread except that a duration matched government bond is used. The I-spread uses a fixed rate or swap rate as the benchmark rather than a duration matched government bond. The Z-spread is the incremental spread, that when added to the government spot rate curve, would discount the bonds cash flow to it price. An option-adjusted spread is much like the Z-Spread but accounts for volatility in interest rates over time to generate multiple future pathways of interest rates and future cash flows. In other words, the option-adjusted spread is simply the Z-spread excluding the premium to compensate for the option risk. For this reason, the option-adjusted spread is lower than the Z-spread of a callable bond. For all credit, the excess return can be determined by taking the spread-time product and adjusting downward to reflect the risk of spread changes and credit risk.
Top-down and Bottom-up Credit Strategies
When the investment manager assesses credit, top-down or bottom-up strategies can be used. Bottom-up strategies involve the identification of the bond universe and sector. Data is then analyzed to determine what the excess return might be while keeping any eye on other differences between bonds that could impact returns. These differences include liquidity, portfolio diversification, and risk. The investment manager will than overweight if there is high relative value. If there are two issuers with similar credit risk, the investment manager will purchase the bond with the greater spread to benchmark rate. Top-down managers on the other hand develop a microenvironment view that considers gross domestic product and default rates and will then assess the impact this will have on credit risk and interest rate risk. The manager will look at historical patterns in credit risk changes and spreads to see if macroenvironment conditions are predictive. The manager will than overweight bonds that are believed to provide excess returns over time. The top-down manager will often use several measures of credit quality including:
- average credit quality;
- average option-adjusted spread;
- average spread duration; and
- the product of duration and spread.
Liquidity, Tail Risk, and International Credit Markets
Liquidity risk in credit markets can prompt the investment manager to hold more cash and government securities when liquidity needs are high. Derivatives can also be used if the underlying security has low liquidity or exchange-traded funds when temporary changes are desired to alter portfolio exposure. Secondary market liquidity can be used as a gauge. Measures for secondary market liquidity include trading volume, spread sensitivity to fund outflow, and bid-ask spreads.
Liquidity measures are often important during tail risk events. Tail risk stems from the investment manager underestimating the probability of an outlier event occurring. These events are accounted for in the “tail” of the normal probability distribution curve, when their likelihood of occurrence is much higher. Tail risk in credit portfolios can be quantified using scenario analysis, historical scenarios, and hypothetical scenarios. Tail risk management involves quantifying risk and holding highly liquid securities, diversifying the portfolio, and using tail risk hedges such as options or credit default swaps.
Liquidity and tail risk are concepts that are both relevant to investment in international credit markets. These markets are often characterized by high exposure to the commodities and banking sector. A sudden drop in commodity prices could lead to a tail risk event. In international credit markets, it is common to see government guarantees on credit, however, foreign rights are often unclear. The bond rating for private credit in these markets is generally capped at the domestic government level. In other words, company issued debt will have a lower rating than the country in which it is domiciled. To mitigate liquidity, currency, and legal risk considerations, the investment manager will often diversify across geographic regions. It is important to note that structured finance products offer an alternative to corporate bonds that allows the investor to earn high yield, tailor risk, and further diversify. Structured finance products include mortgage-backed securities, asset-backed securities, collateralized debt obligations, and covered bonds.
Implications for ESG
Having covered some of the foundational concepts of fixed-income credit strategies, we now turn our attention to ESG and sustainable investment considerations. Credit investors must have a deep understanding of the companies in their investment universe and how sustainability issues can impact credit strength. A best-in-sector approach and be used to differentiate strong ESG performance. This could include exclusionary screens on credit from industries that are viewed to be fundamentally unsustainable such as the manufacturing of controversial weapons or employing child labor [2]. Another ESG selection method is to set thresholds for businesses that are ESG leaders relative to others in the sector. Some investment managers may even seek to engage companies on issues like climate change, diversity and inclusion, and sustainability disclosure in order to gain a better understanding of ESG-related investment risk and to drive changes from management that will make the business more resilient through the credit cycle.
There is evidence to show that poor ESG behaviors can lead to a decrease in a firm’s enterprise value. This has implications for equity and credit investors. Increasingly, investment managers are considering ESG risk in a similar way to credit risk. Empirical research has found that firms with lower ESG performance produce more unpredictable investment returns [3]. Further, credit score analysis may be used as a method for detecting investment opportunities from companies with positive ESG scores. In short, movement of credit spreads relative to the market are mostly caused by measures in credit risk, but ESG risks are also influential. Ensuring that ESG risk is measured precisely is important for accurately predicting the impact on credit risk and company valuations. This means that companies with comprehensive ESG disclosures are likely to have a more accurate credit risk analysis and will be best positioned to reap the benefits of sustainability performance.
Conclusion
As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment
References
- https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
- https://www.finews.com/news/english-news/advertorials/41299-incorporating-sustainability-into-corporate-credit-strategies
- https://www.hermes-investment.com/ukw/wp-content/uploads/sites/80/2017/04/Credit-ESG-Paper-April-2017.pdf
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