ESG in credit markets – what’s material?

Andre Bertolotti and Jaime Maihuire Irigoyen from BlackRock Sustainable Investing share a first-of-a-kind “materiality matrix” showing which ESG characteristics appear most financially relevant across various global credit industries.

Sustainable investing – the combination of traditional investment approaches with environmental, social and governance (ESG) insights – is spreading to all pockets of fixed income markets. Evidence is mounting that focusing on sustainability factors can help investors build more resilient portfolios.

When it comes to applying ESG insights in credit markets, we find some early evidence that a deeper understanding of materiality can help deliver a financial edge. What do we mean by materiality? It’s the connection between exposure to given sustainable properties and returns or risk, as we write in our new paper Sustainability: the bond that endures.

Organizations such as the Sustainability Accounting Standards Board (SASB) and Task Force on Climate-related Financial Disclosures (TCFD) have been leaders in identifying and communicating the importance of materiality-based analysis, particularly on environmental and social factors.

Much of our understanding of which sustainability metrics are most relevant to returns or risk – i.e. material – is based on studies of equities. Yet companies issue a broad range of other securities beyond common stock. To get better insights on how bond investors can integrate ESG characteristics, we developed a first-of-a-kind “materiality matrix” for the global credit market.

Our starting point: six broad sustainable categories that we see as defining the E, S and G properties of companies. See the graphic below.

We applied our fixed income analytics and quantitative tools to measure the connection between these six categories and variations in global credit spreads. This helped us to see which of the three overarching ESG pillars best explained global corporate bond returns since 2015, after managing for common risk factors such as duration, credit ratings, country and currency. For this analysis, we considered the ESG characteristics of each parent issuer and analyzed the performance of its most liquid bond.

Overall, our research suggests each of the three ESG pillars are of roughly equal importance for both credit and equities markets. We find much higher materiality for the “G” in ESG than the base case, both in equities and credit markets. Our analysis also finds a moderately lower role for “E” and “S.” Yet our analysis showed more materiality variation at the sector level. These results are shown in the materiality matrix below.

The matrix shows which ESG characteristics we see as most financially relevant across global credit industries. Just one of our industry specific-findings: We found a meaningful link between financials valuations and our two “E” categories. Since bank operations themselves have little exposure to environmental factors, what could be affecting valuations? We believe investors are considering the fossil fuel and green energy exposure in banks’ loan books. For example, banks’ loans to fossil fuel producers may be at risk of future losses in a scenario in which carbon taxes are introduced.

How might an investor use the information in a financial materiality matrix? We see potential use as a tool for security selection: an investor could overweight issuers with exposure to the sustainability metrics that we find are most relevant for each industry. Our research suggests that tilting toward such exposures can potentially improve portfolio performance. Read more in our full paper Sustainability: the bond that endures.

Andre Bertolotti, CFA, is Head of Global Sustainable Research and Data for BlackRock Sustainable Investing and a contributor to The Blog.

Jaime Maihuire Irigoyen, Sustainable Investing Research Associate, is a member of BlackRock Sustainable Investing.

Investing involves risks, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

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