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Fresh off the heels of the 2021 UN Climate Change Conference (COP26) earlier this month, there a few points worth remembering about environmental, social and governance (ESG) investing.
Undoubtedly, COP26 amplified the spotlight on climate change and sustainability related investing, but as advisors already well know, related investment concepts have been growing for some time and clients are more frequently inquiring about how they can align their portfolios with environmentally friendly virtues.
Another point that advisors are well-versed is that the current landscape of funds focusing on sustainability and climate awareness is largely dominated by equity-based products. Fixed income strategies in this arena are only beginning to proliferate and represent a new frontier for environmentally virtuous investing.
Over time, that could be a good thing because the fund universe is in need of some refreshing. More importantly, there are valid reasons to be implementing ESG and climate considerations into the bond evaluation process, particularly when it comes to corporate debt. Let's explore why.
Leveraging Green Spreads
Last month, I highlighted a recent report by MSCI Research that explains why climate risk matters with corporate debt. Long story short, that research finds that under a 'Net-Zero 2050 (Average Extreme Weather)' scenario, 16% of corporate debt currently sporting investment-grade ratings could be downgraded to junk status while 27% of high-yield bonds could be lowered further into junk territory.
Ominous statistics to be sure, but there are avenues for asset allocators to get out in front of this scenario. Those include green spreads – a concept pioneered by MSCI. In layman's terms, a green spread gauges the environmental component score of ESG ratings while encompassing a corporate bond's credit rating and sector.
The MSCI ESG Rating consists of the three pillars in ESG and those pillars are built on related scores.
“For example, the environmental pillar, a measure of firm performance with respect to environmental issues, is broken down into multiple key issues, which range from adverse environmental impact on waterways to ecological impacts on natural environments,” according to the index provider. “Investors may use these scores as filters to build bond portfolios that contain issuers with certain targeted characteristics such as heavy involvement in renewable energy or having a low carbon footprint.”
MSCI examined the “E” in ESG in relation to carbon emissions scores. The bonds studied were carbon leaders and laggards with BBB ratings. For those hip to ESG investing, the results weren't surprising.
There's “a persistent difference in leader/laggard spreads based on both the environmental pillar and carbon-emission scores,” notes MSCI. “These positive spreads indicate a small premium for leader bond issuers, meaning that yields on bonds of leaders were lower than those of laggards. As of Sept. 24, 2021, this premium was about 12 basis points (bps) based on environmental-pillar scores and about 5 bps based on carbon-emission scores.”
Other Considerations
An interesting observation from the MSCI research is that the aforementioned group of laggards display some sensitivity to oil prices. That's not surprising because it's reasonable to surmise that some, perhaps a lot, ESG “offenders” are fossil fuels producers.
The lesson there is that green spreads, while useful, aren't foolproof. Not when energy is the best-performing domestic sector as is the case this year.
“Environmental laggards on average benefited from increases in the price of oil and suffered with declines. For example, the more than 50% increase in the price of oil through Sept. 24, the last date in our analysis, may have supported current spreads on laggards and offset the potential effects of climate change and more aggressive climate policy,” adds MSCI.
Just remember green spreads are new, not widely used (yet) and could be sensitive to oil prices. Those disclaimers aside, this tool could be useful for evaluating credit opportunities in an increasingly environmentally sensitive investment landscape.
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