Why high yield bonds could be the next ESG frontier

Photo by Towfiqu barbhuiya on Unsplash.

By Lila Fekih & Mark Remington, Co-Portfolio Managers of the New Capital Sustainable World High-Yield Bond Fund at EFG Asset Management 

Equities have garnered the most attention in the ESG boom, but debt is predicted to be a major growth driver. 

Selecting high yield securities has always required heightened due diligence but when ESG factors are included, the analysis is even more challenging.

Potential developments such as prospective environmental regulations, carbon taxes, social change and pressure on corporate governance, disproportionately affect high yield companies. This is partly because their higher levels of leverage mean the effects of change can be magnified in asset valuations.

Investors today rely heavily on data, but disclosure and data linked to environmental, social and governance metrics can be less comprehensive in the high yield space than for other types of security.

However, this makes this area of the market arguably an untapped ESG opportunity, especially given the huge swathes of capital that have already flooded into mostly tech-driven equity ESG plays.

Drilling down 

To invest in the high-yield market through an ESG lens involves sophisticated data harvesting and analysis.

This is increasingly the case given the rising supply of ESG or sustainability bonds being issued by high yield firms.

It’s crucial to isolate a firm’s ESG risks and consider what measures the issuer is putting in place to mitigate these and whether they are comprehensive enough to mitigate the potential downside.

One key element is how well a company’s senior leadership team can adapt to the new paradigm and recognise ESG factors in its pay, policies and performance indicators. These can be positive pointers for investors who are increasingly evaluating the wider costs and opportunities which different businesses and sectors face.

Some may already be sustainable, others may need to pivot, whilst some may be dinosaurs destined for terminal decline.

Making the journey

It’s vital to view sustainability as something that must be achieved rather than simply excluding any firm that doesn’t already have perfect ESG credentials.

One could make the argument that some companies with the most progress to make in respect of their ESG credentials could deliver the most outsized gains, as well as having the greatest marginal gain for society and the environment.

As these companies mature and become ESG leaders, their valuation metrics are likely to improve.

This notion is supported by studies which have shown that bonds from companies with higher ESG scores outperformed those with low ESG scores during the 2008/09 financial crisis.

So, doing well by doing good brings benefits during bad times as well as good.

Achieving equilibrium 

It’s also vital for investors to balance their portfolio with securities from companies that have to, and importantly can, make big strides in terms of their sustainability credentials, with those that have already made them.

Opportunities to invest in such companies will make ESG debt more compelling and encourage a significant capital reallocation into sustainable debt.

ESG assets under management hit $35 trillion globally in 2020, according to Bloomberg Intelligence, with ESG debt funds accounting for just $3 trillion of this.

However, ESG bonds are now widely viewed as one of the key growth areas in the sustainable investing space, with predictions that by 2025, they could account for $11 trillion of a total $50 trillion ESG fund market.

The momentum and sea change is already happening; investors may want to assess the opportunities now before the ESG debt space becomes as crowded as its ESG equity peer.

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