Equity investing with an environmental, social and governance (ESG) focus is clearly gaining momentum in Asia, spearheaded by the likes of Japan’s Government Pension Investment Fund.

But now there’s also a fast-growing body of research showing the positive impact of focusing on ESG elements when investing in bonds – and the development of the fixed income market in Asia seems to be reflecting that.

Some institutional investors are already well aware of the benefits of such an approach.

Ever since it began operating in January 2016, the China-backed Asian Infrastructure Investment Bank has found that fixed income assets with higher ESG ratings tend to have lower portfolio volatility, said Lee Dong-ik, who leads AIIB’s investment operations for the finance and industry sectors. 

Lee Dong-ik

The bank needs to maintain a sustainable return on investments and to do so it invests in Asian corporate bonds that are “ESG-aligned”, Lee said. They still offer better value and yields than those in the US, he explained.  

Identifying top-quality Asian bonds that also rate highly in terms of ESG requires a research-driven and bottom-up approach, Lee said.

AIIB employs asset managers to help it in this regard. For instance, in July the development bank, which aims support the building of infrastructure in Asia, tasked Aberdeen Standard Investments with managing a $500 million debt portfolio with an enhanced ESG focus.

The portfolio comprises mostly Asian infrastructure-related bonds, including green issuances, with ESG factors fully integrated into the investment process and portfolio management, it said at the time.

GROWING EVIDENCE

An expanding amount of research is supporting AIIB’s view of the benefits of an ESG focus on fixed income assets.

Last week JP Morgan Asset Management published a study that back-tested portfolios of investment-grade, high-yield and emerging-market corporate bonds, comparing their benchmarks against a portfolio constructed with an ESG overlay. The test period ran from January 31, 2007 through March 31, 2019.

ESG-tilted strategies exhibit lower volatility, smaller losses and, in some cases, marginally increased risk-adjusted returns, said Bhupinder Bahra, London-based co-head of quantitative research in the global fixed income, currency and commodities group at JPM AM.

The study also found that investments in bonds with a low governance score didn't perform well even if the debt in question was highly rated by credit rating agencies. 

Bhupinder Bahra

Similarly, other recent research has indicated an explicit link between the ESG performance of a company and its level of credit risk.

CREDIT RISK LINKS

A study by Witold Henisz and James McGlinch of the University of Pennsylvania’s Wharton School describes cases of companies with relatively weak ESG performance that later experience high-profile negative ESG events leading to measurable increases in credit risk.

These cases include Goldman Sachs and the 1MDB scandal in Malaysia in 2018, German car maker Volkswagen’s emissions debacle and US bank Wells Fargo’s sales practices.

The study provides investors with clear evidence that higher-performing companies by ESG criteria experienced lower incidence of adverse material events. Meanwhile, companies with lower ESG performance than their industry peers experienced a higher incidence of “adverse material events”.

Such evidence is likely to mean asset owners put more focus on the ESG performance of the companies issuing the bonds they buy.

It also appears to be helping to drive increased issuance of ESG-aligned debt in Asia, which had previously been relatively scarce.

The green bond market hit a first-half issuance record of $117 billion in the first six months of 2019, incorporating a quarterly record of $66.6 billion of green bonds sold, according to rating agency Moody’s. Asia Pacific issuers accounted for 23.8% of the total, while European issuers represented over half of the total, according to the agency.

* 'ESG, Material Credit Events, and Credit Risk’ was first published on July 2. Henisz and McGlinch analysed data for a sample of 342 companies from 13 industries, excluding financial services, over the period of 2009 to 2017.