Now could be a crucial time for investors to fully recognise the importance of integrating environmental, social & governance (ESG) factors into the investment process, according to Hermes Investment Management’s Mitch Reznick. 
Hermes’ head of sustainable fixed income said that pricing ESG factors in to bond holdings can help investors identify risks and prevent poor performance.
Reznick (pictured) said: “Pricing of these non-financial factors – ESG risks – is necessary insofar as they have a material impact on fundamentals of the company and therefore the pricing of the changing valuations of securities.
“We believe that ESG factors have an impact on cash-flows and, if that’s the case, they do on enterprise value. And if they do on enterprise value, then they will also impact on credit risk.
He added: “The distance between the level of debt and the full value of a company is something called ‘implied equity’.
“As [the distance between] implied equity widens, the company grows and does better and credit risk declines, and as implied equity narrows than credit risk rises, because the cushion begins to disappear.”
It is important to take each of the ESG factors in turn to identify potential issues facing companies.
The ‘G’ of ESG – governance – is a key issue for Hermes, said the fixed income specialist, but also more easily quantifiable and tangible for analysts and investors.
“Any one of those factors can have a more meaningful impact depending on the situation, but our studies have shown that governance is [key] for the sovereign and corporate credit space,” he said
“Most important, and probably the reason it’s the most heavily weighted. But not at the expense of the others: you can’t forsake E & S to only look at governance.
“If the fish stinks from the head –and poor governance implies that – they’re probably not going to be terribly focused on environmental & social concerns.”
Reznick said that while awareness of environmental issues is widespread, they are currently mispriced because it is “difficult to understand the timing and the impact of climate change on real company assets”. However, it does not mean that environmental factors are completely devoid of influence.
The firm’s views have been backed up by a recent piece of research it carried out showing the strength of the link between ESG and the riskiness of sovereign debt.
Hermes’ Reznick said that its research into ESG factors on the spreads of credit default swaps (CDS) suggest that there are strong reasons for governments to embrace better standards.
He explained: “You can draw a straight line from ESG factors to credit risk, and engagement and governance is the constructive dialogue you can have with a company to encourage them to enhance and improve their behaviours.”
Hermes analysed the relationship between five-year CDS spreads and ESG scores for 59 countries between 2009 and 2018.
The report found that there was a strong correlation between ESG scores and sovereign credit ratings.
“Countries with the lowest ESG scores have, on average, the widest CDS spreads, and countries with the highest ESG scores have the tightest spreads,” the report’s authors noted.
“Integrating ESG factors in sovereign risk analysis is just as strong an imperative as it is when analysing credit risk opportunities.”
Extrapolating the results of implied CDS spreads, they plotted the pricing chart for sovereign bonds. While the results of this study were “substantiality similar” to the 2017 primary study, according to Reznick he was surprised by the implied credit curve.
The relationship between implied sovereign CDS spreads and ESG scores
Source: Hermes, Beyond Ratings as at May 2019
“It’s really interesting. If you look at the sort of dispersion of the spreads in the range of the key scores, there’s no real pattern necessarily,” he said. “But what also surprised me was how the implied credit curve is nearly linear.”
Reznick added: “There’s a lot more curvature in the credit one: it was very flat in the beginning, and then it goes suddenly very steep.
“So, in the beginning, the implied credit curve that we drew was quite flat for high quality from the ESG point of view. Then it goes very steep for lower quality, whereas for the sovereign it’s a bit more linear. I guess that surprised me a little bit.”
The objective of this research, according to Reznick, was to contribute to the ongoing conversation over incorporating sustainability into investing as well as highlighting that ESG investing doesn’t have to come at a cost. Quite the opposite, in fact: failing to price in ESG factors now will come at a severe cost.
This is particularly pertinent more than a decade on from the global financial crisis, which was driven by some questionable behaviour in markets.
“2008 was a long time ago,” said the Hermes sustainable fixed income head. “In terms of the response to investing, corporate governance and behaviour and transparency are all related to the effects from 2008. But it’s more than that.
“It’s taken 11 years to effect change because of that event.”
He concluded: “We’re trying to contribute to the collective group-think along the ESG journey. And yes, there’s a component of trying to remain at the vanguard of ESG integration and thought leadership, but it’s only out of necessity.”