We have done extensive work on the relationship between sovereign CDS spreads and Brandywine Global’s own ESG scores, which has shown that countries with poor ESG scores have the potential to offer value by improving ESG metrics over time (see Chart 1).
This article shifts the focus to corporate bonds. We look at, all else being equal, the question: Does a strategy of investing in issuers with low ESG ratings perform better than investing in issuers with higher ESG scores over time when the low-rated issuers are improving or likely to improve their respective ESG scores?
ESG Improvement Drives Performance
Using data from MSCI from 2007 to 2019, we analysed the effect of a two-notch ESG upgrade on the excess return of these stocks in the MSCI universe in the 12 months following the upgrade. Chart 2 shows the results of this analysis and demonstrates clearly that companies with poorer ESG ratings (CCC) at the time of the two-notch upgrade performed considerably better in the 12 months following an upgrade than companies with higher ESG ratings (BBB).
When conducting our bottom-up credit analysis, we often find that bonds trading at a discount also possess greater sustainability risks. This concurrence is why we at Brandywine Global have spent significant time and effort ensuring that ESG integration remains fully complementary to our existing investment process and philosophy. The findings of this ESG momentum analysis complement our top-down and bottom-up investment process to help uncover securities that are potentially mispriced, offer value, and have the potential to appreciate in value.
Over the last several years, the market has commanded a premium for ESG leaders and stars, and a reason why we seek to invest in companies with potential or realized ESG momentum. Looking for companies that are likely to have their ESG ratings upgraded over time helps feed into our valuation frameworks much like looking for companies for which we think the credit rating agencies are likely to upgrade their credit ratings. We believe sustainability risks should be accounted for like any other traditional headwind. For example, my colleagues and I on the PRI’s Credit Rating Advisory Committee continue to work with the rating agencies to encourage the inclusion of material sustainability risks in credit ratings and outlooks. We look for potential sustainability catalysts and ratings upgrades in the same vein. Our sovereign research that demonstrates the strong correlation between country credit ratings and ESG scores can be used as a proxy for corporate credit as well.
Identifying Potential ESG Upgrades
We uncover the potential for ESG rating upgrades in several ways, including:
As part of our active ownership and engagement strategies, we endeavor to be a catalyst for change and improvement among our portfolio companies. We want to see improvement in companies’ ESG metrics; in situations where we are not satisfied, we will engage directly with those companies to hopefully influence or direct that improvement. Subsequently, we aim to capture the potential upside in performance.
Mobilizing against Climate Change
One material issue that demands immediate attention is climate risk. We believe climate change presents significant investment risks that are not fully reflected in asset prices. Furthermore, while investors may be able to gauge the potential impact of the most likely climate scenarios given global warming and greenhouse gas emissions trends, tail-risk or catastrophic climate-related events could still occur and with significant or unknown economic costs. The 2021 United Nations Climate Change Conference, known as COP26, in November in Glasgow, UK, will be a true test of commitment to addressing climate change and encouraging the transition toward reducing greenhouse gas emissions on a global scale. Of the $100bn pledged by developed nations to help developing nations adapt to climate change, there is still a significant shortfall which needs to be addressed if the developed world is to maintain credibility in this key area.
As a member of the Net Zero Asset Managers initiative, we are committed to both identifying and assessing climate-related investment risks as well as influencing the necessary changes to meet the goal of net zero greenhouse gas emissions by 2050 or sooner. Brandywine Global is firmly of the belief that the energy transition toward net zero needs to be well funded. We also believe that refraining from investing in a company or country because it appears to be a large emitter of greenhouse gases may be detrimental in the longer term. There are two issues here. First, we aim to be responsible owners; if investors sell these low ESG names, indiscriminate owners—who may not be committed to active engagement and influencing the change that needs to occur—may buy them. Second, there is the moral dilemma of penalizing a country or company because it does not have the funds to promote more climate-friendly changes, such as moving to gas from coal in the case of South Africa. Denying debt or equity investment before a company or country has even had the opportunity to set out its plans for the transition to net zero is not in the best interest of society as a whole or investors. As a manager, we will continue to engage with issuers on this topic and meaningfully fund the transition for our companies that demonstrate a realistic and credible net zero commitment. It is also a reason why we will be positioned in some high-emitting sectors over the next few years.
While active ownership and engagement have traditionally been the domain of the equity investor, we are increasingly seeing our ability as corporate bondholders to drive the conversation with companies through our own active engagements as well as through collaborative engagements, such as Climate Action 100+, an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change. These engagements also help to uncover additional information, offer access to senior management, and deliver perspectives on a company that otherwise might not be available. Engagement can help recognize companies dedicated to improving ESG metrics or identify shortcomings and encourage remediations for companies with low ESG scores, which likely may improve financial performance over time. We view this as a win-win, advancing progress on important ESG issues like climate change while delivering value to investors.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.