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Bond managers see it as a crucial ingredient of risk management

By Matt Wirz 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (June 20, 2018).

Once a fringe concept, environmental-, social- and governance-based investing has hit the mainstream.

A weighty-sounding proclamation by JPMorgan Chase & Co. in a recent report trumpeting the arrival of so-called ESG investing may sound like rhetoric from Occupy Wall Street: "Civil society is calling on the financial-services industry to advance sustainable development goals," the report said.

But the many banks, investment firms and financial-data providers scrambling to roll out new ESG-branded products -- particularly in bond markets -- are also trying to get out a less-lofty message. Investing by ethical and environmental standards is no longer mainly about making the world a better place, they say. It's about making more money by avoiding losses.

"The driver has moved from an ethical and moral dimension to 'this makes for good risk management,' " says My-Linh Ngo, an ESG analyst for BlueBay Asset Management, a London-based investment firm that manages about $60 billion of bond portfolios. "This is what gives you 'alpha,' " or better performance than a standardized benchmark, she says.

Changing climate

Also referred to as socially responsible investing, or SRI, this approach began in earnest in stock markets in the 1990s, but spread to bonds in recent years, spurred in part by new European regulations in response to climate change and the financial crisis.

ESG also offers the promise of new revenue streams for investment firms, banks and the data providers that cater to them. Growing numbers of investors, especially millennials and European institutions, want investment options that align with their ethical and social goals -- excluding firearms manufacturers, for example, or focusing on renewable-energy companies, analysts say.

Bond-buying giants, including BlackRock Inc., Pacific Investment Management Co. and Franklin Templeton Investments, all unveiled ESG initiatives in the past 18 months, as did midsize investment firms Neuberger Berman Group LLC and Eaton Vance Corp. Bond-index operators MSCI and Bloomberg Barclays have teamed up to offer an ESG variant of the widely followed Bloomberg Barclays Aggregate bond indexes.

Bond managers have always evaluated corporate governance and social stability, among other more qualitative aspects of the borrowers they lend to. The difference that the ESG lens brings is an application of a systematic evaluation of such variables to every investment decision.

For now, the frenzy to adopt ESG seems to have outpaced the market capabilities to actually apply the concept. Indeed, there is still no consensus on how to measure variables like social impact and good governance or how to incorporate them in the decision to buy or sell an individual bond. Credit-rating firms, the de facto arbiters of bond quality for many institutions, don't yet provide ESG ratings or guidance on how to do so.

"We have yet to see a credit-rating agency publish a transparent and detailed methodology for analyzing ESG considerations as part of their credit analysis," Jonathan Bailey, Neuberger Berman's head of ESG investing, wrote in a research piece in December.

'Evolution' of investing

Ultimately, though, incorporation of ESG into debt markets is inevitable, Mr. Bailey said in an interview. "It's just an evolution of good investing."

That evolution got a big push about two years ago, when a critical mass of European pension funds, insurers and other institutional investors began only awarding new business to money managers with ESG capabilities, analysts and fund managers say. Investment firms that hadn't yet hired ESG specialists began doing so and offering ESG bond funds.

As ESG spread in the financial industry, a new idea began to take hold: Investors who incorporated environmental, social and governance risks into their analysis of all bonds could reduce losses over time.

Grading companies on executive governance, for example, could help fund managers sidestep the bonds of a pharmaceutical company ripe for regulatory blowback over price gouging or opioid pushing. Measuring the political support of governments when comparing countries with similar economic strength and debt profiles might allow fund managers to pick which countries' bonds would perform better over time.

Critics of such ideas say that while some ESG characteristics can be quantified, allowing analysts to compare different bonds uniformly, others are qualitative and poorly suited to such evaluations. Variables like gender composition of a corporate board and youth unemployment can easily be assigned a number, but the susceptibility of a political leader to corruption or a corporation's tolerance for dissent in middle management is harder to reduce to a figure.

That challenge is an opportunity for analysts and fund managers to prove their worth, says Franklin Templeton global bond fund manager Michael Hasenstab, who in February announced the creation of an index that quantifies ESG inputs and distills them into a single numerical score. Franklin's country analysts feed the index with data by assigning scores of 1 to 10 to a range of ESG variables and forecasting how they expect the scores to change in the medium term.

"What is really interesting is the one- to three-year forecast," Mr. Hasenstab says.

Franklin, which famously bought billions of dollars of bonds from Ukraine and Hungary, is willing to invest heavily in countries with poor social cohesion and governance as long as their scores are expected to improve. It also may avoid stable countries where ESG conditions are deteriorating. Mr. Hasenstab has sold or is betting against bonds of Poland and the U.S, which have solid scores but also have the highest potential to deteriorate among the 44 countries on Franklin's ESG index.

Mr. Wirz is a Wall Street Journal reporter in New York. He can be reached at matt.wirz@wsj.com.

(END) Dow Jones Newswires

June 20, 2018 02:48 ET (06:48 GMT)

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