Understanding ESG in Credit Portfolios

05 Mar 2018

The inclusion of Environmental, Social and Governance (ESG) factors in investment decisions is being widely adopted, including within credit portfolios. However, little research is available which explores the impact of ESG on credit returns. Importantly, we see ESG as being distinct from the perspective of Socially Responsible Investing (SRI) or Ethical Investing (EI) as these are very subjective and primarily driven by ideological preference. This paper analyses how ESG factors interact with credit quality, how they affect the pricing of credit, and finally how they affect credit returns.

Overall, all three ESG factors have a small impact on the price of credit. However, the market tends to under-price the importance of Governance factors, and over-price the importance of social factors, which means that a portfolio with high Governance scores could outperform a portfolio of low Governance scores with similar credit ratings and industry classifications. Having a bias to better social practices could, on the other hand, create a drag on performance (this is a choice that some investors may make on ideological grounds).

A difficulty with using ESG scores within portfolio construction is that they are often stale, and so when incorporating ESG into portfolio management it is best to directly consider ESG factors as part of the overall credit analysis process, with credit analysts responsible for doing their own analysis and providing more up-to-date research than is available from central sources. Doing so can generate more opportunities to add value through ESG in fixed income investing.

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