Using traditional fundamental projections, the investment horizon starts to get blurry beyond six months. We believe assessing the current and most important projected environmental, social, and governance (ESG) factors can extend the investment timeframe from months to years. In addition to managing downside risk, having a longer-term perspective generally improves returns by lowering risk-management costs.

Although credit investors don’t have an actual vote like equity investors, debt comprises a bigger portion of corporate balance-sheet capital.¹ Raising and lowering the cost of debt capital can meaningfully impact corporate cash flows, returns, and executive compensation. The shorter duration of debt in comparison to equity compels management teams to address questions from credit investors regarding fundamental and ESG factors and outlooks with more frequency.

For example, management must satisfy short-term credit investors’ concerns every few months in the commercial-paper market. Front-end market technicals of lender concentration² and a narrow pricing range (short-term credit investors are more focused on a return of capital and less on a return on capital) mean that if investors are unsatisfied with fundamental or ESG factors, they may choose to not invest, effectively eliminating access to the market.

ESG assessments also impact credit access and costs indirectly in private markets through financial intermediaries such as banks and insurance companies. This provides credit investors a variety of direct and indirect engagement opportunities to address and price pre-financial costs and benefit.

Fundamental vs. ESG Integrated

ESG-integrated research refers to systematically assessing and incorporating non-traditional governance factors, and stakeholder costs and benefits derived from ESG data into the investment process. However, it doesn’t mean that the investment process will lead to the achievement of any ESG outcomes. ESG assessments and outlooks focus on material unaccounted externalities that will accrue and eventually materialize on the financial statements, impacting the credit-risk premium. While credit investors have always incorporated non-financial factors into their investment analysis, we believe ESG-integrated research is an enhancement to traditional fundamental research.

There are studies showing a high correlation between ESG analysis and ratings and traditional fundamental research and credit ratings.³ As with traditional research and investing, alpha production is not derived from assessing historical data; it relies on identifying current mispricing of future states. Analysis of ESG factors offers additional insights into longer-term, future disruptions.

ESG-integrated investing is no longer rare. Incorporating ESG factor analysis into traditional fundamental research is becoming table stakes. A recent survey indicated that around 80% of credit investors use ESG integration either as their sole strategy or combined with one or more other strategies.

There are three key characteristics of ESG research and investing:

1. Anecdotes are replaced with data;

2. Materiality tailored to industries and markets and;

3. Engagement

Importantly, as with fundamental research and investing, ESG-integrated research and investing doesn’t make moral or ethical judgement on behalf of asset owners. The intention is simply to have more comprehensive information to drive better investment decisions.

While ESG rating agencies, third-party research, and data providers can be helpful, their output often lacks consistency, nuance, and forward-looking investment value.

Doing Your ESG Homework

Just as with fundamental research, access to quality data and tools is critical for thorough ESG integration. However, while ESG rating agencies, third-party research, and data providers can be helpful, their output often lacks consistency, nuance, and forward-looking investment value. Their coverage can often be limited outside of developed-market asset classes, such as listed equities and credit. As noted above, simply assessing historical information isn’t enough to source alpha. Proprietary tools, resources, and a seasoned research team with ESG accreditation are needed to project the trajectory of fundamental ESG factors.

With more than two decades of experience and over forty researchers dedicated to ESG and sustainable finance, Schroders has developed several proprietary tools⁴ that help investors identify investment opportunities and risks, including:

1. Context - Schroders’ proprietary ESG analysis tool gives our researchers and portfolio managers insight into the sustainability of a company’s business model. Context is based on the principle that the long-term health of a company relies on the strength of its relationships with stakeholders.

2. Sustainex - Quantifies the impact that companies have on society by translating environmental and social impacts into financial costs and benefits. The tool is built on academic and industry studies that map, measure, and quantify dozens of different positive and negative externalities.

3. MUSE - A unique tool for assessing municipal investments that derives an overall sustainability score driven by more than forty ESG factors from a variety of sources, including several proprietary metrics. This score can then be calculated for counties, states, or regions of the country. This is an example of a proprietary tool providing coverage of an asset-class area for which third-party data isn’t as readily available.

Exclusions vs. Best-in-Class

Asset owners have always limited or excluded certain assets from their investment portfolios for a variety of credit and non-credit reasons. Some examples may be excluding high yield, emerging market, foreign currency, or financials. Before ESG data was available, asset owners relied on simple limits or exclusions to tune exposures and further their environmental and social objectives.

When asset managers integrate ESG factors into their investment process, it doesn’t increase or decrease investment opportunities. Rather, it seeks to maximize returns given risk by focusing on best-in-class investments regardless of market, asset class, sector, industry, and issuer. In our view, ESG-integrated best-in-class investing is an enhancement to simple exclusionary investing.

Transition Financing

Transition financing, which provides capital to companies to support their efforts to reduce externality costs, is one of the most controversial topics of sustainable and impact investing. Some regulators⁵ and asset owners require or choose to exclude such industries or issuers, thereby constraining a portion of the investable universe. While some exclusions are generally accepted in sustainable investing,⁶ we believe regulation in the US will focus on best-in-class instead of exclusions and allow transition financing to encourage engagement with problematic industries or issuers to avoid surrendering influence.

ESG Integrated, Sustainable, Impact or Philanthropy?

At Schroders, we think there is a spectrum of approaches to ESG research and investing, according to asset-owner priorities (FIGURE 1). This runs from taking ESG factors into consideration (integrated), to promoting ESG characteristics (sustainable), trying to achieve positive sustainability outcomes alongside returns (impact), and doing good, in which return isn’t the primary motivation (philanthropy).

Sustainable funds offer asset owners the added opportunity to contribute to improving ESG factors while minimizing uncompensated ESG risks. 

Sustainable funds offer asset owners the added opportunity to contribute to improving ESG factors while minimizing uncompensated ESG risks. The threshold for impact investing is higher than for sustainable investing. Impact funds promote the reduction of future environmental and social costs through positive inclusion of sustainable themes. 

Sustainable and Impact Investing: Cost or Benefit?

There’s little debate regarding the merits of ESG integration, which is defined as enhancing the traditional fundamental investing framework with an assessment and outlook on ESG factors.⁷ However, there's a fierce debate regarding whether sustainable or impact investing provides a cost or benefit to investors.

A prudent investor analyzes all current direct and future indirect costs and benefits accruing to debt and equity capital providers. Ignoring unaccounted external ESG costs may expose credit investors to controversies and drawdowns. Likewise, understanding positive ESG externalities could allow for longer-term investing in structurally best-in-class bond issuers.

Unfortunately, there aren’t generally accepted measurement standards for sustainable or impact investing, which makes it impossible to compare outcomes. Efficient frontier theory assumes that constructing a portfolio that contributes to (sustainable) or promotes (impact) ESG objectives reduces the investable universe and thus lowers potential returns. However, there are offsetting and complicating factors:

1. In markets with minimal dispersion, the opportunity loss can be minimal for issuers that score poorly on ESG metrics. Measurement is intrinsically connected to the time period assessed.

2. Another important factor is a favorable ESG technical as more capital is invested, driven by growing client demand for ESG products.⁸ This technical could be positive for ESG-favorable sectors and issuers and negative for those that score poorly from an ESG perspective.

3. Lastly, as credit exposures range from a moment to perpetual, a sustainable or impact fund may out- or under perform depending on duration—even on debt issued from the same issuer.

As we don’t have standard definitions and only a limited history in fixed-income sustainable or impact investing, we cannot quantify the economic impact of pricing ESG costs or benefits. We can only say that we expect that the returns on sustainable and impact strategies will be different in comparison to fundamental or ESG-integrated funds.

Hartford Schroders Sustainable Core Bond Fund

The Hartford Schroders Sustainable Core Bond Fund centers around a value-driven style that helps to identify when and where to take risk across the investment-grade universe. Our sustainable approach isn't a moral or negative screening approach and while there may be nuances between the individual corporate issuers, the broad sectoral asset-allocation and top-line risk exposures will be very similar.

Our approach to sub-advising the Sustainable Core Bond focuses on best-in-class issuers. 

¹ Total outstanding fixed-income stands at $70 trillion according to Bloomberg Multiverse as of 4/30/22.

² CFA Institute, "Concentration Risk on the Buy-Side of Credit Markets: The Causes," 8/31/21.

³ Risk Control, "ESG and Credit Rating Correlations," 2/4/22.

⁴ Schroders' proprietary ESG tools are designed to enhance the research and evaluation process but don't guarantee favorable investment results or the identification of all risk.

⁵ EY, "EU Action Plan–Deep Dive on Disclosure Regulation (SFDR)," 12/9/20.

⁶ United Nations Global Compact, "Delisted Participants," as of 2022. United Nations Global Compact violators are corporations that have material ESG exposures and risk incidents related to the ten UNGC Principles.

⁷ Barclays Live, 2022.

⁸ Bank of America Global Research, 2022.