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How The G in ESG Can Help Manage Bond Risk

How The G in ESG Can Help Manage Bond Risk

In periods of stress, ESG bond funds have outperformed non-ESG funds.

By Bonnie M. Wongtrakool

While first popularized within equity markets, interest in environmental, social and governance (ESG) investing has also become a popular topic among bond investors, as the record-breaking bull market run shows signs of vulnerability. With a wall of worry continuing to build, fixed income investors have shifted from asking “will ESG reduce my returns?” to “how can ESG help mitigate my downside risk?”

Studies of equity portfolio construction have illustrated how ESG can reduce downside risk and volatility. With historical fixed-income ESG data reaching critical mass, evidence is emerging that these benefits can apply to bonds as well.

During normal conditions, ESG bond funds historically performed in line with or slightly better than non-ESG bond funds. Yet in periods of stress, ESG bond funds meaningfully outperformed.

Several analyses have identified positive relationships between the ESG practices of countries and their sovereign spread performance.  What about the diverse universe of corporate bond issuers?  

Let’s look at the energy sector as one example. During the 2014-2016 oil and commodities downturn, a high ESG quality corporate bond portfolio would have outperformed a low ESG quality corporate bond portfolio by 3.6%, according to Bloomberg analysis. Even better, a portfolio comprised of energy issuers with best-in-class environmental practices would have outperformed one with the worst-in-class issuers by 6.5%.

Corporate governance practices, also known as the “G” in ESG, play an important role in differentiating issuers. Companies with better governance have the potential to suffer less from negative ESG-related events than those with poor governance. Conversely, the market is more likely to reward companies for reaching positive milestones if they consistently practice good governance than if they have shortcomings.

Here are five governance issues we look at closely when analyzing corporate investment opportunities.

Disciplined balance sheet management: As bondholders with a long-term value approach, we prioritize balance sheet discipline and stable cashflows over short-term growth. Accordingly, we look for management to demonstrate clarity on leverage targets and plans to achieve them.

Transparency in reporting: We expect management teams to take a proactive approach to disclosure. Issuers that provide information selectively or irregularly raise red flags, as do those that narrow the scope of their disclosures and resist or sidestep reporting covenants (specifically in the high yield sector). Changes in auditors or fiscal years may also warrant concerns.

Access to management: Ideally, management teams should be available to meet with us and be responsive to our concerns. Open lines to senior management can help us assess growth prospects against leverage levels and financing plans and to press for improvements in ESG practices.     

Decision-making processes: We take pause if there are dual CEO and chairman roles. We also evaluate the independence and qualifications of board members, and the diversity of viewpoints and experiences within company leadership.

Protection of bondholder interests: We exercise caution if an issuer has share classes with different voting rights. In addition, we examine whether executive compensation is aligned with our generally longer time horizon.

Across all sectors, ample room remains for companies to improve how they address and manage ESG risks. Although bondholders do not have voting rights, engagement with management can be a lever for change, as issuers have begun to appreciate the linkage between their cost of capital and ESG. 

As a fundamental, active, fixed income manager, Western Asset will continue to work with issuers to develop better governance practices, and encourages other bond investors to do the same. The result may not just be lower portfolio risk, but also more resilient corporations around the globe. 


Bonnie M. Wongtrakool, CFA, is Global Head of ESG Investments and Portfolio Manager, Western Asset Management

TAGS: Mutual Funds
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