Sustainable corporate bonds withstand the financial storm

ESG factors can be a valuable addition to credit risk analysis.

The experience of investors during the financial crisis underscores the necessity to combine traditional credit analysis with a sustainability screen in order to manage the financial, ecological and social risks associated with corporate bond issuers. Sustainable businesses have been much less affected by the negative impacts of the financial crisis than companies that do not operate in a sustainable way. “Only when the tide goes out, do you discover who’s been swimming naked,” said Warren Buffet, and the quote is particularly true with regard to the recent turmoil in the financial markets. In an environment of scarce liquidity, a collapse in market demand and a general sense of economic uncertainty, the short-comings of a purely financial view of credit risk have been exposed. Traditional credit analysis has failed to identify many of the company-specific risks that are related to unsustainable business practices; either because they are not on the radar of credit analysts or simply because they are difficult to quantify using conventional risk measures. However, not paying attention to unsustainable business practices can have dramatic consequences for creditors. The sharp rise in the credit spreads for corporate bonds suggests that the risk aversion among investors has climbed to new levels, although first signs of easing are now becoming visible.Widening credit spreads (the difference in the yields from safe government bonds and corporate bonds with the same terms to maturity) have forced down prices of corporate bonds. Likewise, the cost of default insurance has reached historical highs. In many cases investors have put their faith blindly in the credit scores awarded by the leading rating agencies. But these agencies mainly assess the debtors’ measurable financial risks. As a consequence, many risks related to the way a company conducts its business practices, such as threats to a company’s reputation through defective products, compensation claims, or disputes with relevant stakeholders, have systematically been underestimated. However, these risks have a direct impact on the credit risk and may result in significantly higher default rates. The failure of rating agencies and conventional credit analysts to incorporate these non-financial risks, suggests that risks from unsustainable business practices have been neglected for many years. This has led to overoptimistic credit ratings with the result that interest rates paid by unsustainable issuers – i.e. the risk premium – did not match the credit risk for these companies. During difficult times such as these, the value-added of implementing a sustainable investment strategy becomes most obvious, particularly for fixed
income investors. Apart from the financial aspects (e.g. solvency, capital structure), this investment style also assesses the environmental and social risk of companies and their business models. This add-on research component is an important indicator of how a company deals with existing conflict potential as well as its efforts to avoid long-term risks. Hence, it makes sense to combine the traditional credit analysis with a thorough sustainability screen in order to get a fair judgement about a company’s real credit risk. Such an approach provides valuable information to investors in evaluating whether the credit spread of a corporate bond fairly compensates the company-specific risks. The overal superior return of corporate bonds from sustainable issuers (in comparison to their non-sustainable peers) since the start of the financial crisis – and espe¬cially during the fourth quarter of 2008 – confirms the validity of the sustainability component as complementary tool for risk monitoring. According to Sarasin Sustainable Investment, several factors can be identified to explain this outcome. In general terms, sustainable corporateissuers tend to have higher credit ratings, which turned out to be beneficial as the market has seen a significant increase in the demand of high quality bonds. Furthermore, bonds issued by non-sustainable companies have seen a much stronger widening of risk premium, measured through 5-year credit default swaps. In most industries, the difference in CDS has increased from a few basis points at the end of March 2007 to far greater average values just two years later (exceeding 100 basis points in the case of the financial industry). Another important observation is that some business models, which were hit hardest during the crisis, have a priori been excluded or underweighted in sustainable bond mandates due to their critical sustainability profile. These include automobiles, airlines, fossil energy, mining and construction, as well as some sub-segments such as investment banks. These findings illustrate the systematic advantages of including a screen of corporate issuers on non-financial risks and it highlight the attractions of a sustainable investment style for bond investors.
Andreas Knörzer is managing director and head of Sarasin Sustainable Investment.