The “gold rush” to socially responsible investing is here. But, across the fixed income market, environmental, social and governance risks are still not widely understood — or adequately priced in.
Last year, environmental, social and governance-linked (ESG) bond funds netted roughly $102bn, a record level of net inflows, according to data from research group EPFR. Searches for “ESG” in Google reached an all-time high in February 2022. And investors around the world advertised the sophisticated ESG standards that they apply across asset classes.
However, ESG products are still often treated separately from the core investment business and ratings are still not always a primary or decisive part of the credit risk assessment process. And, even when they are, there is no universal standard for what constitutes an ESG risk.
For example, in 2021, there were still upgrades in the credit ratings of coal companies, mortgage booms in flood zones, and schools embroiled in sexual assault cases that successfully raised money in the municipal bond market.
“It’s obvious to me that there are ESG risks that are not priced into fixed income markets,” warns Tom Graff, head of fixed income at Brown Advisory, the investment manager.
The commercial mortgage-backed securities market is a clear example of this, says Graff. Floods are getting worse, more frequent and more widespread because of climate change, and that rising risk is often not priced in.
A big rise in flooding costs for US companies would hit mortgage-backed securities in the $4tn commercial property market. Building damage caused by extreme flooding — worsened by climate change — could lead US businesses to spend $13.5bn on replacements and repairs in 2022, according to estimates from research firm First Street Foundation.
Such repairs are also expected to force commercial buildings to shut their doors for 3.1m days this year, adding to corporate costs. In total, the financial impact of lost business from flooded commercial buildings is projected to set local economies back $49.9bn by the end of December. Those costs are expected to rise dramatically in coming years.
Natural disasters can be particularly risky for commercial and residential mortgage-backed securities. These bonds are linked to properties around the country but they tend to be highly concentrated in major metropolitan areas where there are more homes and businesses. Most of those metropolitan areas are coastal or situated close to large bodies of water — and all are at heightened risk of flooding.
Roughly a fifth of all commercial real estate value in the US is located in New York, Miami and Houston, according to CoStar data. All of those cities are flooding hotspots.
These risks are not new. Morningstar identified roughly $26.6bn in CMBS that was put at risk by Hurricane Irma which, in 2018, hit the Caribbean and the Florida Keys. Data provider Trepp also found that $29.6bn in CMBS was threatened by Hurricane Harvey. US bank Morgan Stanley estimated that $8.5bn in CMBS was at risk during 2021’s Hurricane Ida. And Fitch Ratings identified $6.3bn in CMBS jeopardised by Hurricane Dorian. Nor is the causation limited to hurricanes: more extreme weather has led to floods from higher rainfall and deluged rivers.
But major floods have, thus far, only led to a modest number of bond defaults and have not yet led to a meaningful change in pricing, even as storms have become more frequent and intense.
ESG risk is similarly underpriced in the municipal bond market, argues Erin Bigley, head of fixed income responsible investing at AllianceBernstein. Issuers that are providing educational or healthcare services, for example, may be assumed to embody ESG principles, even when they do not.
“We have found that there are issuers where our ESG scores have indicated risks that are not priced into the market,” says Bigley. “Even on the very high-quality side.”
While Bigley did not cite any specific cases, the municipal bonds of the University of Southern California may provide an example of a pricing anomaly. USC has been embroiled in a sexual assault case since 2018, in which a campus gynecologist was accused by hundreds of students of abuse. The university has agreed to pay out more than $1bn for these claims, a fact that led Moody’s to downgrade the school’s credit outlook to negative in 2021. The prices of the school’s municipal bonds, by contrast, were largely unaffected by these specific events.
But the mispricing of risk can also create opportunities for investors.
Take energy independence risk, for example. It is not always a primary consideration when evaluating the credit risk of sovereign bonds. However, when a country is cut off from foreign sources of energy — for geopolitical reasons, such as the conflict in Ukraine or because of changing trends, or legislation — it raises costs for companies and consumers, slows growth and, in turn, raises the chances of default.
Conversely, countries that have prioritised energy independence may be underpriced. Yvette Klevan, portfolio manager at Lazard Asset Management, cites Morocco, which is boosting its energy security by creating some of the world’s largest solar farms. “Sometime in the future, we believe that could be a fiscal upgrade story,” she says.
Source: Financial Times