Assessing the Impact of ESG on Fixed Income
Historical analysis suggests that improving the ESG profile of a fixed-income portfolio would not have undermined performance over the past decade.
Fixed-income assets are the core allocation for many institutional investors. However, much of the academic research into how environmental, social, and corporate governance (ESG) factors influence investment performance has focused on listed equity markets rather than fixed income. There has been little independent research into the effect of applying ESG factors in fixed income.
That is why Insight Investment engaged Bayes Business School—the business school at City, University of London—to independently study the effect of ESG investments on the financial results of a European fixed-income portfolio. Our aim in commissioning this study was to expand the body of work available for reference. While the industry has a feeling for how ESG factors impact performance in fixed income, Insight felt it was important to commission a rigorous, independent academic study on the topic.
The study provides academic support for the practice of considering ESG risks in fixed-income portfolios and gives investors a better understanding of the influences on performance. It also reinforces the importance of understanding the purpose and limitations of using ESG data.
Key Findings of the Research
The Bayes research team used constituents of the iBoxx EUR Corporates bond index1, sourced from IHS Markit, to create a hypothetical ESG reference fixed-income portfolio. Then they applied ESG factors in a variety of scenarios, analyzing the effects of each change on the reference portfolio’s performance across the decade that ended on December 31, 2021.
The study found that enhancing the ESG profile of the portfolio would not have led to any deterioration in its risk-adjusted performance. We take this result to mean that investors should feel confident that integrating ESG considerations into their fixed-income investment decisions could be worthwhile.
The study resulted in four key findings:
1. Higher ESG ratings actually improved risk-adjusted returns, but investors must beware of the subtleties. The researchers split the universe of bonds in the portfolio into quintiles based on each composite’s ESG score, then evaluated the relative financial performance of each ESG-determined quintile. During the decade under review, the bonds in the top quintile (highest ESG rating) outperformed those in the bottom quintile (lowest ESG rating) by roughly 3 percent, a statistically significant margin.
To ensure the top quintile’s outperformance represented an ESG effect and not an inadvertent tilting toward certain high-performing sectors, the research team adjusted the exposure of each quintile to match the sector exposure of the reference portfolio. Although some of the top quintile’s outperformance relative to the overall portfolio was, indeed, derived from a sector effect, the greatest influence came from the ESG effect. The reverse was true for the bottom quintile: All outperformance relative to the overall portfolio was derived from an inadvertent tilt toward higher-performing sectors, while the ESG effect had a negative impact on financial performance for companies with the lowest ESG scores.
However, a simple comparison of top vs. bottom quintiles based on aggregate scores misses several subtleties. The study found that improving ESG scores does not necessarily correlate with enhanced returns, and that consistent outperformance was concentrated in two specific time periods: the three years ending in early 2016, and from late 2018 to early 2020.
It also found that focusing on individual environmental, social, and governance factors can create mixed results. As an example: When the researchers ranked fixed-income investments by environmental scores alone, rather than their full ESG activities, top-quintile portfolios outperformed the bottom quintile. However, if they adjusted the bottom quintile by sector, the bottom quintile outperformed the top quintile.
Indeed, results at the subcategory level could prove disappointing. For instance, companies with the highest scores for human rights significantly underperformed the overall portfolio, with almost 100 percent statistical certainty.
While more ESG-oriented portfolios tend to create better risk-adjusted returns over longer time periods, benefits may prove elusive over shorter time periods. Additionally, focusing on a single ESG measure or subcategory does not reliably indicate superior performance, perhaps due to sector-concentration risks.
2. ESG scoring tilts can marginally improve historical performance, but excluding low-ranking bonds is impractical or not impactful. One way to increase portfolios’ ESG scores is to exclude low-ranking bond issues. The study found that excluding the portfolio’s bottom quintile of issuers, as determined by their ESG scores, did not significantly impact the portfolio’s financial performance.
The study also found that unless the researchers focused on only the top 20 percent of bonds by ESG score, there was no discernible difference in the portfolio’s financial performance. However, excluding 80 percent of securities in a fixed-income benchmark is not a practical approach; liquidity and default risks would become far more acute in such a concentrated portfolio.
A more popular way to increase a portfolio’s ESG score is to tilt individual bond weights up or down relative to the overall portfolio and to determine their weighting based on their ESG scores. The research suggests that using a tilting formula can lead to some marginal outperformance, as Figure 1 illustrates.
3. Excluding controversial sectors would not have hurt performance. A common approach to addressing ESG issues is for investors to exclude controversial sectors such as tobacco, mining, and oil-and-gas producers. Such an approach is typically taken to reduce the externalities produced by certain entities held within a portfolio, rather than to reduce the financial risks associated with ESG issues.
Regardless, the historical returns from a portfolio that excluded such sectors proved statistically identical to the baseline portfolio. It seems that using an exclusionary approach over the past 10 years would not have detracted from investment returns, given that these sectors accounted for only a small proportion of the portfolio.
4. Enhancing the ESG credentials generally led to a reduction in the tail risk of the portfolio. One supposed advantage of ESG integration is the positive impact exerted on tail risk—i.e., the expectation that the worst returns experienced over the long term will be less severe for the top ESG bond issuers than for those at the bottom. To confirm the veracity of this claim, the study examined a series of risk metrics focused on measuring tail risk in the portfolio.
Figure 2 shows the results for each quintile based on composite ESG scores. The data delineates a general increase in tail risk as ESG scores decline, from the first quintile (highest ESG scores) toward the fifth (lowest ESG scores). Bayes observed similar results when looking exclusively at environmental and social scores, but not when focusing only on corporate governance.
It is difficult to draw definitive conclusions regarding the relationship between ESG ratings and downside risks in a corporate-bond portfolio. However, these results arguably show that ranking investments using either the composite ESG or the environmental-specific rating can help reduce the extremity of downside outcomes.
Understanding the Limitations of ESG Data
Insight believes this study should provide comfort to fixed-income investors that are looking to further integrate ESG criteria into their portfolios. At the same time, it reinforces the importance of understanding the purpose and limitations of using ESG data.
The reality is that different ESG-rating agencies may produce very different answers because they employ very different methodologies. By contrast, credit-rating agencies have the more precisely defined task of calculating the probability of default, meaning their methodologies are better aligned and their ratings are typically bunched far closer together.
Major limitations of ESG ratings include:
- Coverage gaps. Not all data providers have the same coverage on each and every issue. For example, if there are 10 issuers in a given market, ESG rating provider A might offer ratings for the top five issuers, while provider B rates only the bottom five. This is an extreme example but illustrates why relying on ratings from only one provider creates data gaps. Instead, companies and investors should build their own ratings based on data from all the providers.
- Varying quality. Even when ESG rating agencies have data on a bond issue, there may be weaknesses if some of that information is incomplete, irrelevant, or stale.
- Different methodologies. Different data providers can have widely differing ESG ratings for the same issuer, while differences are typically much narrower for credit ratings.
It’s important when using ESG data, and particularly data associated with composite ESG ratings, to determine whether the chosen methodology aims to reflect financial risks—such as how an entity is exposed to, and manages, ESG issues that could affect its creditworthiness—or broader nonfinancial performance of an entity regarding ESG matters, such as the environmental impact of its operations.
In Insight’s experience, most ESG ratings are more focused on financial risks, but different providers take a variety of approaches today.
It is vital to come to grips with what actually underpins the ESG data you are using in your analyses before you draw any firm conclusions. However, the Bayes study offers some hope to believers that integrating ESG factors into portfolio management does not need to have a cost in terms of the portfolio’s financial performance.
1 The iBoxx EUR Corporates bond index is the property of Markit Indices GmbH and/or its affiliates (“Markit”). iBoxx™ is trademark of Markit. For more information, see: https://ihsmarkit.com/Legal/disclaimers.html.