Reframing sustainable investing for high-yield bonds

Initially, investors focused on excluding certain companies by sector or activity, largely guided by environmental, social and governance (ESG) data from third parties. There seems to be some intuitive merit in exclusion-based strategies that prefer companies with sustainable business practices already in place. But within capital markets, this has led to a split between ‘green’ companies that sustainable investors more readily direct capital to, and ‘brown’ companies that often lack the capital to execute their sustainability ambitions. Moreover, ESG disclosures in the high-yield market tend to be lacking, making traditional data-based screening methods less effective.

Why focusing on existing sustainable companies may miss the point

Recent research indicates that allocating exclusively to companies that are already 'green' has little impact on their behaviour [2]. Worse still, data shows that sustainability ‘laggards’ can perform worse from a sustainability perspective, precisely because they are starved of capital that can help them transition. In fact, by allocating to existing sustainable companies, investors may be missing out on future sustainability leaders. For example, a high-emitting chemical company may be shifting its strategy towards developing green hydrogen and using its infrastructure to transition away from fossil fuels. In this example, although not fitting traditional 'green' criteria, the company clearly has significant transition potential. This illustrates how investing solely in existing sustainability leaders may hinder the emergence of future ones.

The case for investing in companies that are earlier in their sustainability journey

Investing in companies that are earlier in their sustainability journey can help produce positive risk-adjusted returns. A study from Barclays attempted to assess the relationship between company ESG scores and investment performance. It found that the ESG return premium was positive for both equity and fixed-income markets across the US and Europe [3]. What’s more, it was shown that ‘ESG momentum’ (i.e. a firm’s change in ESG score over time) generates a further unique risk premium over and above that generated by the overall ESG return premium.

Put simply, the research from Barclays suggests that companies showing larger improvements in their ESG scores earned higher returns when controlling for all other variables. As such, this appears to confirm that looking beyond acknowledged green companies to those at earlier stages of the transition journey (which is quite typical in the high-yield market), can deliver better risk-adjusted returns and progress on sustainability issues.

The opportunity for high-yield engagement

In our view, investing in earlier-stage ESG companies can have the twin benefits of providing much-needed capital to companies to finance their transition efforts, as well as helping investor prospects for alpha generation. But providing capital alone is rarely enough. Active engagement also has a major role to play in terms of identifying companies with high ESG potential and in helping to drive positive ESG results. This is particularly relevant in the high-yield market, where there can be significant upside potential from effective engagement. 

An important factor is the typically higher frequency of high-yield companies accessing public debt markets, which naturally entails more opportunities for investors to engage. More broadly, the high-yield debt universe is rich in diversity, with a vast array of companies at various stages of their sustainability journey. This is also quite helpful in terms of meaningful engagement opportunities.

The power of high-yield engagement

In the high-yield market, it’s quite common for companies to have more limited ESG disclosures, which is invariably because of a lack of associated reporting infrastructure. For investors directly engaging with such companies can make up for this by helping to fill in the data gaps and thus better assessing the true scope for ESG progress. There can also be a chance of revealing attractive investment opportunities that might not be immediately evident through data analysis alone. Beyond this, a critical factor that direct engagement is ideally suited to establishing is the existence (or otherwise) of the necessary intent on the part of managers to make ESG improvements.

Once both the scope and intent for ESG progress is established, then engagement can become more constructive for all parties. This can include setting meaningful targets that improve investor and company alignment, as well as providing a more structured and measurable pathway for sustainability progress.

Summary

In summary, we believe there is significant scope for high-yield bond investors to promote improved sustainability outcomes in companies. However, allocating to companies that score highly on ESG metrics likely misses the point. Instead, we think more meaningful impact may be possible by selectively allocating to companies that are earlier in their sustainability journey, and that otherwise might lack the capital to execute their transition plans. For investors, there is also good evidence that suggests allocating to companies that are earlier in their sustainability journey can produce positive risk-adjusted returns.

When it comes to identifying the companies that are earlier in the sustainability journey, and which may have the potential to become future sustainability leaders, we think direct engagement is the key. Successful direct engagement can help to fill in data gaps and establish both the true scope and the necessary intent on the part of the managers to drive ESG advancements.