Martin Foden, Head of Credit Research at Royal London Asset Management, explains how ESG and credit analysis must be integrated to achieve superior investment returns.
‘ESG' is all the rage in investment management, but there are many challenges in applying ESG or sustainable considerations across asset classes. ESG investing started as an equity specialism, so much of the data and analysis used today is still centred in equities. Some investment firms use these tools and ‘read across' from equities to credit. Their claims about multi-asset sustainable investing appear reasonable at a high level, yet they quickly unwind for two reasons.
First, only around 40% of the bonds in the sterling credit index have a public equity profile. Not only does a focus on companies with a public equity listing greatly reduce the opportunity set, it is also the very area of the market where information dissemination is already most efficient. Secondly, while there are clearly similarities, equities are fundamentally different from credit. What works for one isn't always relevant or important for the other. For example, bondholders have no ownership of a company and therefore direct influence can be limited, particularly for larger-cap companies.
More importantly, the risk/return payoffs are completely different. Unlike equities, credit risks are asymmetric: upside returns are capped, however the company performs, yet deterioration can lead to negative returns, through default, forced sale because of fund restrictions or mark-to-market losses.
The relevance of ESG factors to credit investing is obvious: risk doesn't discriminate and its origin doesn't matter. And given the skewed nature of returns there is, arguably, no asset class to which sustainability is more important than credit.
The importance of a research-based investment process
We believe it is hard to outsource effectively the analysis of ESG risks to third parties. As well as the limited scope of equity-based platforms, the apparent simplicity and convenience of an ‘ESG score' often fails to capture the vagaries of the real world and the sheer idiosyncrasies of credit. We know this inefficiency well from the role of credit ratings in the market: while broadly helpful, the over-distillation of information into one rating creates distortions that active investors can exploit.
The only credible solution is proper, bottom-up research and an investment process that acknowledges the false distinction between traditional credit and ESG analysis. However, while ESG analysis needs to be intrinsic to the process to be credible, achieving this in practice is not easy. At RLAM, our credit and ESG teams collaborate to improve information discovery and dissemination, but getting the right decision-making sequence is key - ultimately, the final decisions to buy or sell and portfolio positioning are still made by fixed income specialists, given their experience of evaluating and mitigating credit risk.
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