Strengthening ESG risk assessment through dynamic credit analysis

Investors increasingly recognise the benefits of ESG risk analysis in protecting the long-term value of their investments. As investment managers look to assess ESG risks, inadequate ESG disclosures, inconsistent definitions, diverse and often subjective interpretations imply that there are no short cuts to this process. We cannot merely rely on external ESG evaluation; active fixed income managers with significant credit research capabilities would be able to better understand the ESG risks of issuers and add value to investors.

Investors are starting to appreciate that focusing on Environmental, Social and Governance (ESG) factors help reduce their exposure to long term risks. Increasingly, regulations, such as more stringent emission standards and heavier penalties for violations of environmental standards have raised the materiality of ESG risks to issuers.

Thanks for subscribing!

Follow us :

According to a survey conducted by the CFA Institute, investors expect environmental and social factors to have a greater impact on credit spreads and government bond yields going forward. See Fig. 1.

Fig.1. % of respondents who answered “often” or “always” to the question – “How often do ESG issues affect corporate bond and sovereign debt yields?”

strengthening-esg-risk-assessment-through-dynamic-Fig1

Research has shown that higher ESG ratings correlate with lower credit spreads, and issuers with good ESG track records tend to benefit during periods of flight to quality. A study by Bank of America Merrill Lynch shows that 73% of Asia Pacific companies which were downgraded1 between December 2009 – 2018 had below median ESG scores. Higher ESG scores, however, did not correlate with upgrades. This suggests that the consideration of ESG factors can help mitigate credit risks.

The lower long-term risks resulting from an ESG-focused investment approach can be seen from Fig. 2. The JACI ESG indexes, especially the JACI ESG high yield index, have lower volatility while delivering returns that are comparable to the broader bond indexes. MSCI also found that companies with high or upgraded ESG ratings generally experienced lower volatility2.

Fig. 2. Annualised return and volatility (Since December 2012)

strengthening-esg-risk-assessment-through-dynamic-Fig2

ESG risk assessment – it’s complicated

ESG risks may not be immediately apparent and could gestate over a longer time period. Research by MSCI suggests that governance factors tend to have a greater impact on profitability, idiosyncratic and systemic risks in the short term (1 year) as they are most directly linked to short term events and incident risks. Environmental and social factors, on the other hand, are more important over longer periods. Not only do time horizons impact ESG factors, there are also sectoral differences to consider. Governance factors, for example, may matter more for the financial sector while environmental factors may be more critical for the materials and energy sectors3.

As such, careful analysis is required to identify companies that are undergoing structural changes and assess their ability as well as readiness to adapt to such changes. By understanding the long-term viability of an issuer’s business model, active managers like ourselves can potentially avoid downside risks and protect the value of the portfolio’s underlying investments over the long run.

ESG risk evaluation often goes beyond assessing a set of numbers but instead requires evaluating a myriad of “soft” and sometimes subjective factors. ESG factors are expansive and diverse, which makes them almost impossible to distill into a single number or rating that indicates “good” or “bad”. For example, how should one assess the environmental impact of a nuclear power plant or a hydro-electric dam? Such grey areas have led us to devise innovative ways to assess the corresponding risks and apply them in a consistent manner across our investment framework.

The challenge in evaluating ESG risks can be seen from the fact that even ESG rating providers have different ESG ratings for the same company. Fig. 3 shows that while really “good” and “bad” ESG performers may be obvious, there is often greater subjectivity in rating companies that fall in-between.

Fig. 3. Comparison of ESG scores between two rating providers

strengthening-esg-risk-assessment-through-dynamic-Fig3

No short cuts

As such, we believe that there are no short cuts in ESG evaluation. This is particularly so in Asia with its inconsistent ESG standards and inadequate ESG disclosures. See Fig. 4. In fact, China only recently removed clean coal projects from its list of green bond financing targets, in order to bring some of its ESG parameters up to par with global standards. The lack of alignment between disclosure regimes across different jurisdictions also makes cross-country comparisons difficult. While many governments and institutions have pushed for greater ESG-related disclosures, Bloomberg’s ESG Disclosure Score Index (which ranks the usefulness of a firm’s disclosure information) gives the median company across 17 countries4 a score below 50%.

Fig. 4. ESG disclosure breakdown by exchanges

strengthening-esg-risk-assessment-through-dynamic-Fig4

We believe that active fixed income managers add significant value through their in-depth research of companies and understanding of ESG issues.

At Eastspring, we do not simply rely on external ratings and assessments but draw on the strengths of our large credit research team. Their experience and depth of knowledge of the issuers help us make more informed decisions. While credit worthiness is a key pre-requisite, all securities and issuers are subject to an additional set of ESG risk evaluation criteria. We have formally incorporated corporate governance, historically an important factor in evaluating issuer risks, into our proprietary ESG evaluation framework.

We also do not automatically exclude issuers in controversial industries. Instead we prefer to assess the effort that such companies are making to remain relevant and whether they may be effecting positive changes within their industries during the process. Some coal-powered operators, for example, are transiting to renewable sources of energy. We acknowledge these positive initiatives and may keep such issuers within our portfolios. We believe that active engagement with investee companies goes a long way to improve ESG practice and management.

An evolving journey

A comprehensive ESG risk assessment will remain challenging until we achieve better quality ESG disclosures and greater consensus within the industry of what ESG means (ie a common taxonomy). While companies are already making progress on this front, thanks to the numerous international, regional and national initiatives, active fixed income managers that have significant credit research capabilities would be able to better understand the ESG risks of issuers and add value to investors.

As the market evolves, we continue to refine our ESG framework with our learnings. We aim to embed our ESG framework across all our fixed income strategies as we seek to deliver sustainable long-term performance for investors.

For Use with Professional Clients / Qualified Investors Only. Not Approved for Further Distribution or Use with the General Public.

The information and views expressed herein do not constitute an offer or solicitation to deal in shares of any securities or financial instruments and it is not intended for distribution or use by anyone or entity located in any jurisdiction where such distribution would be unlawful or prohibited. The information does not constitute investment advice or an offer to provide investment advisory or investment management service or the solicitation of an offer to provide investment advisory or investment management services in any jurisdiction in which an offer or solicitation would be unlawful under the securities laws of that jurisdiction.


Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the strategies managed by Eastspring Investments. An investment is subject to investment risks, including the possible loss of the principal amount invested. Where an investment is denominated in another currency, exchange rates may have an adverse effect on the value price or income of that investment. Furthermore, exposure to a single country market, specific portfolio composition or management techniques may potentially increase volatility.


Any securities mentioned are included for illustration purposes only. It should not be considered a recommendation to purchase or sell such securities. There is no assurance that any security discussed herein will remain in the portfolio at the time you receive this document or that security sold has not been repurchased.


The information provided herein is believed to be reliable at time of publication and based on matters as they exist as of the date of preparation of this report and not as of any future date. Eastspring Investments undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. Eastspring Investments personnel may develop views and opinions that are not stated in the materials or that are contrary to the views and opinions stated in the materials at any time and from time to time as the result of a negative factor that comes to its attention in respect to an investment or for any other reason or for no reason. Eastspring Investments shall not and shall have no duty to notify you of any such views and opinions. This document is solely for information and does not have any regard to the specific investment objectives, financial or tax situation and the particular needs of any specific person who may receive this document.


Eastspring Investments Inc. (Eastspring US) primary activity is to provide certain marketing, sales servicing, and client support in the US on behalf of Eastspring Investment (Singapore) Limited (“Eastspring Singapore”). Eastspring Singapore is an affiliated investment management entity that is domiciled and registered under, among other regulatory bodies, the Monetary Authority of Singapore (MAS). Eastspring Singapore and Eastspring US are both registered with the US Securities and Exchange Commission as a registered investment adviser. Registration as an adviser does not imply a level of skill or training. Eastspring US seeks to identify and introduce to Eastspring Singapore potential institutional client prospects. Such prospects, once introduced, would contract directly with Eastspring Singapore for any investment management or advisory services. Additional information about Eastspring Singapore and Eastspring US is also is available on the SEC’s website at www.adviserinfo.sec. gov.


Certain information contained herein constitutes "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof, other variations thereof or comparable terminology. Such information is based on expectations, estimates and projections (and assumptions underlying such information) and cannot be relied upon as a guarantee of future performance. Due to various risks and uncertainties, actual events or results, or the actual performance of any fund may differ materially from those reflected or contemplated in such forward-looking statements.


Eastspring Investments companies (excluding JV companies) are ultimately wholly-owned / indirect subsidiaries / associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.