Incorporating ESG mitigates credit risk

clock • 2 min read

For investors adhering to responsible investment dogma, there comes a point when, generally speaking, they need to decide whether to blacklist companies or pursue engagement.

Within a buy and maintain strategy, whereby you are avoiding the flaws of benchmark-driven investing and aiming to mitigate the risk of default and impairments, it is key to rely on in-depth financial analysis to assess the credit profile of each issuer. This credit research process is designed to uncover and delve into the key drivers of a company's business, its sensitivity to various internal and external factors, and its long-term ability to live within its existing capital structure under realistic operating assumptions. In addition, the durability of an investment over the long term is dependent on how sustainable the company's business model is from an environmental, social and governance (ESG) perspective.

Academic research suggests ESG criteria may reflect the quality of a firm's management or act as a leading indicator of slow-burning problems which could later impact creditworthiness. As such, it is imperative to integrate ESG criteria into the credit selection process as this creates a more holistic decision-making process which includes information on certain risks that cannot be readily identified through traditional credit analysis or public credit ratings. With further transparency and accuracy of data on ESG information, long-term investors will have the opportunity to further mitigate those risks of defaults, and adapt their investment policy accordingly.

The long-term investors that are not only looking to mitigate the risk of capital loss but also aim to have a positive impact on the environment and society have different tools to achieve this. The overall ESG profile of their investment can be improved through a combination of thematic screening, investment in "use of proceeds" bonds (e.g. Green, Social and Sustainable bonds) and reporting on social outcomes. The use-of-proceeds bonds market is growing rapidly, both in terms of issuance and type of investment. Integrating those new tools within an impact strategy, would require broader and deeper investment process.

Incorporating ESG factors in the investment process in order to mitigate further the credit risk should be directly done in any existing fund, as this would be consistent with the long term objective of maximising the risk-adjusted return.

As the investors would have to adapt their investment policy and (depending on the expected level of risk) may have to generate some turnover which can be costly, or either hold the bond of any identified issuers to maturity without increasing the exposure over time. This is consistent in the way buy and maintain strategy actively manage the risk within portfolios.

However, for a strategy in which maximising the impact on environment and society is its primary objective, there are times when launching a new fund does make sense in order to focus on specific themes or type of investments. As an example, we have seen over the recent years, a few new portfolios focusing only on green bonds.

Sebastien Proffit, head of Portfolio Solutions, Fixed Income, AXA IM