What Happened with ESG and Quality in Bond Market Turmoil
How Quality Performed in Investment Grade and High Yield
Investors may be surprised to learn about the dispersion of bond spreads during the coronavirus sell-off, they were quite different across sectors, firms and bond issuances. Investors didn’t sell bonds indiscriminately, even amidst panic, they paid attention to the underlying fundamentals. This is important because a wider range of outcomes even within the same asset class creates more opportunity to outperform for investors who make the right investments. Similarly, investors who place the wrong bets face the risk of more significant underperformance.
The dispersion highlights the value of the quality factor, which targets companies with efficient management, profitability and strong cash flows. Using Northern Trust Asset Management’s proprietary quality definition, we observed that quality generated strong performance during this risk-off period in the investment-grade and high-yield segments. Indeed, the highest quality investment grade category (first quintile) was the only segment to generate positive returns. In high yield, the highest quality segment significantly outperformed lower quality segments by 20%.
How ESG Leaders Performed
We think investors intuitively understand that financial quality is an important driver of performance, especially in the bond market dictated by credit ratings. However investors are taking advantage of improving technology and non-financial data collection to gain a deeper and more holistic understanding of credit risk. This is exemplified through ESG metrics — such as labor disputes, health and safety, and effectiveness of management — that all measure a subtly different dimension of corporate sustainability versus only credit ratings.
In our recent blog, Sustainable Investing in Fixed Income: Avoiding the Pitfalls, we highlighted that bonds issued by ESG leaders may offer downside protection during periods of market turbulence. This is the case despite their loose relationship with traditional credit ratings, meaning there is an inherent quality bias associated with ESG leaders even if they don’t maintain the highest credit rating.
The pattern in today’s market is similar to what transpired during the 2012 European sovereign debt crisis and the 2016 energy crisis: ESG leaders offered downside protection.
A deeper look reveals that relative performance by ESG leaders is mixed after controlling for the starting credit rating, but the downside protection offered by ESG is notable especially among the lower credit rated bonds. In Exhibit 3, we show the average performance of ESG leaders minus laggards within each credit rating bucket. This highlights the need for controlling for key drivers of fixed income returns. Naively investing in ESG leaders can be fraught with unintended yield, duration, sector and credit rating biases.
In Exhibit 4, we look at the upgrade-downgrade ratios by ESG leaders and laggards and find that ESG laggards experienced more rating downgrades during the sell-off period. This indicated that non-financial ESG metrics were possibly credit relevant.
ESG in the Post-Pandemic World
While strong financial metrics remain the foundation of an issuer’s creditworthiness, we believe investors will continue to incorporate non-financial metrics into their evaluation process to help mitigate downside risks. Issues such as labor disputes and conflicts in the global aviation industry, food safety concerns for restaurants, and data protection and privacy for technology will increasingly play a role in investors’ decisions. Some of these concerns are already considered by credit rating agencies. However, based on the performance of ESG bonds during this episode, the market may not be pricing all the ESG risks in bond portfolios.
The combination of supply and demand shocks means the global economy may shrink by 3% in 2020, according to International Monetary Fund. Credit markets continue to be under a lot of stress with high yield spreads trading at historically high levels due to the solvency concerns in the energy sector as well as other sectors directly impacted by the pandemic. Significant fiscal stimulus by governments and monetary support from central banks across developed and emerging economies should aid credit markets, but there will be some winners and losers coming out of this crisis. We believe that combining targeted quality factor exposures with ESG metrics will help to enhance returns and manage both financial and non-financial risks.
Learn more about sustainable investing at Northern Trust Asset Management.
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