We believe that applying an ESG approach does enhance returns over the long term. So, if you’d asked me when we launched the Artemis Corporate Bond fund whether we would ever own tobacco bonds, I’d have said it was highly unlikely. I actually said in 2019 that I couldn’t foresee a scenario where we would. While co-head of fixed income at Kames Capital, I oversaw the almost total liquidation of our tobacco bonds across our actively managed portfolios. Embracing an ESG approach doesn’t naturally dovetail with owning tobacco bonds. But the pandemic created a unique set of circumstances which challenged that key ESG assumption, briefly at least, that ESG enhances returns; and active managers like us must always be pragmatic.
ESG investing takes into account the societal impact of a company’s activities. Some business models are debatable, like oil. Releasing carbon into the atmosphere is bad, but diesel engines currently power ambulances and fire engines. We all want to reduce single-use plastic, but are unconcerned about the usage of PPE during the pandemic. Oil companies produce stuff that helps humanity as well. While electric cars produce no CO2 while driving, the electricity that charges their batteries may do. But the carbon released in their manufacture is not debatable because the mining of ore and the production of metal is carbon-intensive. My point is that ESG considerations aren’t always clear-cut.
While people can make up their own minds on the pros & cons of oil and electric cars, few can argue that cigarettes are good for society. As a result, more and more financial institutions have stated publicly that they will stop investing in tobacco. Others have gone further, saying they will liquidate all their holdings over the medium term. This impact can be seen from the long-term underperformance of tobacco bonds in the UK corporate bond market.
Source: Artemis Fund Managers
While tobacco has been used for centuries, the good news is that smoking rates are falling, particularly among the young. Tobacco companies are doing a ‘good’ job of developing the next generation of less damaging products to manage the decline in their customer base. But tobacco companies are fortunate insofar as the addictive nature of their product means the decline in their customer numbers is slow; and tobacco sales are essentially recession-proof.
And here is the dilemma. Tobacco companies are financially very stable. It was obvious in the early days of lockdown that some sectors would struggle, but tobacco wasn’t going to be one of them. Imperial Brands released a trading update at the end of March reaffirming the resilient nature of its products. Despite being one of the most Covid-resistant business models, tobacco bonds fell heavily in the selloff, exacerbating what was already a multi-year slump. The corporate bond market didn’t discriminate much between the vulnerable sectors and the resilient ones in the early days of Covid. Passive funds, large holders of tobacco bonds, effectively sold everything to meet redemptions. As a result, market dispersion was initially very low. Economically this doesn’t make any sense: it’s just a short-term technicality.
At the end of March, central banks announced quantitative easing measures which stabilised the corporate bond market and enabled it to stage a recovery. As with early 2009 when the corporate bond market stabilised in the wake of the global financial crisis, the biggest companies with the strongest balance sheets came to the new issue markets first. The first handful of deals come with considerable premiums to tease bond managers out of their bunkers and start deploying cash again. On 2 April 2020 British American Tobacco (BAT) was one of them, issuing a new euro-denominated bond maturing in 2028. The new bond came at a spread of bunds plus 376 basis points, nearly 50 basis points wider than where its closest existing bond, the € BATSLN 1.25% 2027, was trading. That bond itself had sold off an additional 20 basis points on the announcement of this new deal, on top of a multi-year underperformance of tobacco bonds.
BAT had a market cap of over £67bn that day. It had a Covid-resilient business model which is not only obvious but had been reaffirmed by a large industry peer. Despite BAT’s bullet-proof balance sheet, its bonds had sold off as heavily as the broader market. To compound the economic irrationality, the new deal was coming very cheap relative to its existing bonds that had in turn incrementally underperformed because of the new issue. On that day, no other bond in the broader sterling or European corporate bond market had as compelling a risk/reward trade-off.
In the end, the market recovered and profits could have been made in many other bonds. This in turn could negate the rationale for buying BAT. But what would have happened if the economic and social crisis had deepened and the market had continued to fall? We can be confident that the defensive nature of the tobacco business model would have protected capital much more than most other sectors. To repeat myself, this is a question of risk as well as return.
Source: Artemis Fund Managers
Over six months on as we enter another lockdown, the market isn’t panicking like it was in the middle of March. We know better now the lethality of the virus, the medical community knows better how to help the infected, and we know that a vaccine isn’t far off. These things were far from certain at the end of March and the start of April. It’s important, when debating these issues today, that we reflect on the extreme economic uncertainty the world was facing at that time in the midst of a rapid climb in mortality rates.
Our primary duty is fiduciary. Our job is to deliver superior risk-adjusted returns to help our clients achieve their financial goals. ESG is a tool to help us deliver strong returns, but it is not intended to be a constraint. Our benchmark has tobacco bonds. If our fund didn’t moderate its zero tobacco exposure in the face of this grave economic and social crisis, would we have been acting in our clients best interests? We know that many of our clients agree with our decision to reduce our large tobacco underweight at the start of April. We are also aware that some feel there can never be any justification for holding tobacco. But what 2020 has shown us is that a strict, exclusionary approach to ESG does come at a cost of returns in the short to medium term, particularly when observed through the lens of risk-adjusted returns.
ESG is important to us. The Artemis Corporate Bond fund has a carbon footprint that is 30 per cent lower than the index. The fund has four times as many green bonds as the index. The fund scores well relative to the index when measured against external ESG providers such as MSCI, not that we ourselves target this measure. We believe that ESG does enhance returns over the long run. We continue to believe that the tobacco sector will languish in the long run as more and more investors shun the sector. The fund currently has no tobacco exposure and is unlikely to invest in the sector again. But the pandemic proved a new risk scenario for a very difficult few weeks that challenged established and newer investment norms.
Stephen Snowden is manager of the Artemis Corporate Bond fund. The views expressed above are his own and should not be taken as investment advice.