Sustainable credits: sustainability adds to safety
Investing in the bonds of only sustainable companies is a defensive measure that increases downside protection. Jan Willem de Moor, the Robeco Euro Sustainable Credits fund’s manager, explains.
Key points
Sustainable investing is a new development in the corporate bond universe
Sustainability is an extra way of avoiding losers: in-depth ESG analysis leads to greater awareness of the negative impact of these factors on companies’ credit quality
Euro Sustainable Credits excludes bottom 50% of companies in each sector on sustainability rankings
Upbeat outlook for corporate bonds: environment of moderate growth, rising profits, de-leveraging and low interest rates should support better-quality credits
Although sustainable investing is already relatively common in the equity universe, it is a new development in corporate bonds. In some ways that is rather odd, as one of the main advantages of a sustainable investment approach—avoiding the securities of companies that perform poorly on environmental, social and governance (ESG) issues—is particularly relevant in a fixed income context.
That is because bond investors have goals that are very different from those of equity investors. Equity investors are typically looking for upside; they are trying to find winners. That’s entirely logical, as the best performing stocks have huge upside potential, much more than any individual bond.
Fixed income focus on managing downside risk
It couldn’t be more different on the fixed income side: downside protection is the focus. For a corporate bond investor, the big worry is to be holding the bonds of a company that defaults on its debt or goes bust.
“The core of our investment philosophy is to avoid big losers and manage downside risk,” explains Jan Willem de Moor. “Doing that is more important than picking every winner. And sustainability is an extra way of avoiding losers.”
ESG analysis contributes to a truer picture of the overall risk picture
The reason for this is that in-depth ESG analysis permits deeper insights into companies, ultimately leading to a greater awareness of the negative impact of these factors—one example would be weak corporate governance—on companies’ economic performance and credit quality.
“Using sustainability as an extra factor in the investment decision-making policy, alongside the usual analytical tools such as assessing an issuer's cash-generating capacity, the quality of its cash flows and its ability to repay debt, can generate a more accurate judgment of the risk premium needed to compensate for the total risk,” says De Moor.
Of course, all Robeco fixed income products—including both other credit funds, Robeco Euro Credit Bonds and Robeco Investment Grade Corporate Bonds—now incorporate responsibility factors in their fundamental analysis. That’s also the case for Sustainable Credits.
Bottom 50% of companies on sustainability criteria are excluded
What is different with Sustainable Credits is that the bottom 50% of companies in each sector in sustainability terms is excluded from the portfolio. This restriction on the investible universe clearly means that the fund is heavily tilted towards the most sustainable companies in each sector. “Only the best companies get into the portfolio,” notes De Moor.
On what basis are companies categorized as sustainable or not? The credit team largely bases this analysis on the ESG scores generated by SAM*, Robeco’s Swiss-based subsidiary that focuses exclusively on sustainability investing.
That said, it is possible for the team’s analysts to make recommendations that alter the rankings, so that a company in the bottom half of SAM’s sector rankings could be shifted up into the top half, for instance.
Sector leader BMW is included in portfolio
Let’s turn to the companies that are included in the portfolio. One company whose bonds are held by the fund is BMW. According to SAM’s rankings, the German car-maker has the highest sustainability score in the sector.
“The company has surpassed its peers by exhibiting an unparalleled commitment to environmental issues,” notes De Moor: “So, for example, it strives to conserve environmental resources throughout its value chain. That ranges from production systems to materials used in logistics, as well as the recycling and disposal of used vehicles.”
BMW also illustrates the fund’s philosophy of choosing sector leaders. Other leaders include Xstrata (first out of four in General Mining), Siemens (first out of five in diversified industrials) and Total (first out of eight in Integrated Oil & Gas).
A balanced and diversified portfolio
Despite this focus on the companies with more sustainable operations (and the exclusion of their less sustainable counterparts), the fund still has a portfolio that is balanced and diversified.
“The portfolio is low-medium risk. The beta is not too aggressive,” De Moor explains. "Although we have high conviction in our bottom-up selection, we still manage to keep the ex-ante tracking error below the 3% limit."
Overall, the fund’s biggest positive active positions are in banking, insurance, basic industries and consumer non-cyclical. The biggest underweights are in finance companies, communications and utilities.
De Moor points out that the financials overweight is the result of a combination of top-down and bottom-up factors, while valuation is the key factor behind utilities’ low weighting.
Positive outlook for corporate bonds
The positives from the sustainable approach are currently complemented by an upbeat outlook for corporate bonds in general. “Credit spreads have widened recently, due to worries about the fiscal situation in Europe. While acknowledging this uncertainty, we believe that an environment of moderate growth, rising profits, de-leveraging and low official interest rates will support better-quality credits,” says De Moor.
That’s not all. Credit spreads are still at elevated (i.e. cheap) levels from a historical perspective. In addition, bank deposit rates are likely to remain low for longer in reaction to the current unrest, which should ultimately support the demand for credits. Finally, new banking regulations featuring higher solvency ratios are also positive for credit investors.