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The Influence of ESG on Fixed Income Portfolio Manager Behavior

ESG-on-Fixed-Income

Environmental, Social and Governance (ESG) signals have gained increased attention with investors especially in equities. Existing work has looked extensively at the impact on the risk and return profile of ESG portfolios, their impact on asset pricing and interactions with existing factors.  Moreover, several studies have also noted the different ESG data sources and methodologies can create uncertainty in ESG measurement. However, both adoption and analysis of ESG in corporate bonds has lagged behind equities. We explore the impact of ESG exposures on corporate bond returns and characteristics. We find similar results to previous studies that observe a strong correlation between ESG exposures and corporate default risk. To better understand how potential uncertainty in ESG data and the correlation of ESG to corporate default risk effects portfolio construction, we look at the portfolio exposures and characteristics of the largest fixed income ESG managers. Among several interesting observations, we note that ESG exposures reduce the credit beta of a portfolio to traditional fixed income benchmarks and managers tend to overweight lower rated, longer dated bonds with high ESG score to offset this impact. This behavior by individual managers has broad implications for investors in their own portfolio construction.

Introduction

The increasing interest in investments that target companies with strong environmental, social or governance characteristics (ESG) is evidenced by the large number of new ESG fund launches, the flow of new assets directed at ESG funds, and the myriad of recent research papers devoted to the topic. However, ESG research related to equities has received markedly more attention than research related to fixed income, for several good reasons. First, long-term equity investors will naturally look for information that can reduce the potentially unrewarded 

long-term risks of a stock, particularly given the higher total risk. In this way, ESG information can complement traditional analysis especially for the long-term horizon investors. Therefore, it is not surprising that institutional equity investors are at the forefront of ESG investing. Second, for those seeking an active ESG engagement approach, equity investors can actively engage the company boards on ESG issues directly whereas fixed income investors cannot. Finally, many institutional fixed income investors tend to hold their investments to maturity. Therefore, systematic rebalancing with ESG signals is not as applicable. Before investors can incorporate ESG criteria or signals in their investment process, they must carefully assess the risk and return impact of ESG exposures on their portfolios. An argument can be made in both directions on the impact of ESG on asset returns. If companies are better at assessing their ESG risks and opportunities, that should reduce the discount rate and improve valuations. On the other hand, there could be a sin premium because poor ESG companies could have reputational risk which investors need to be rewarded for. The research in equities has been mixed so far. Atz et al. (2021) review over 1000 peer reviewed research papers from 2005-2020. Studies focused on the impact of ESG from a corporate perspective found a positive impact for ESG. For investor-type studies, ESG was indistinguishable from traditional investing. 

The availability of ESG signals from third party providers for corporate bond portfolios allows us to address the impact of ESG on firm value from the debt side. Unlike equities, several authors have found a correlation of ESG scores to corporate spreads. 

Corporate spreads, referred to as option adjusted spread (OAS) in the below, measure the yield difference between a corporate bond and a maturity matched Treasury bond. The spread is often viewed as compensation for the default risks associated with holding a corporate bond. In addition to spreads, duration is another key metric in assessing fixed income portfolios. The OAS of a portfolio multiplied by its duration is referred to as DTS and is a common metric for assessing a portfolios risk. From Ben Dor et al. 2007, DTS is an ex-ante measure of the systematic credit risk in the portfolio. Funds with higher DTS have higher risk exposure to the systemic credit risk. This is important for investors who are seeking to harvest the credit risk premium (Asvanunt and Richardson 2017). DTS in that sense is like beta in equities. The ratio of a fund’s DTS to its benchmark is a good ex-ante approximate beta, and therefore will be a metric highlighted throughout this analysis

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