Sustainability:

the bond
that endures
Tools and insights for ESG investing in fixed income

Global Insights | November 2019

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Brian Deese
Global Head of
Sustainable
investing
Sustainable Investing

Philipp Hildebrand
BlackRock Vice
is going
mainstream.
Chairman

Evidence is building that a focus on sustainability-related factors

— ranging from carbon efficiency to quality of governance — can
help investors build more resilient portfolios. Many are starting to
Richard Kushel assess their exposure to climate and other sustainability-related
Head of Multi-Asset risks — and regulators around the world are adding to this push.
Strategies and Global The risks can have a material impact on corporate performance,
Fixed Income and may even give rise to financial instability as climate change
affects banks and insurers, the International Monetary Fund
argues in its most recent Global Financial Stability Report.
Ashley Schulten
Head of Responsible
The equity market has played an early role in the history of
Investing for Global sustainable investing. The wide spectrum of different debt
Fixed Income instruments in fixed income meant that data availability was
more patchy, while tools and insights lagged. This is changing
fast. We show how innovations such as ESG bond indexes have
created building blocks that investors can now use to create
sustainable multi-asset portfolios.

We believe it is time for a differentiated approach to sustainable

investing in fixed income. We introduce a new lens for viewing the
sustainability profile of 60 developed and emerging government
debt issuers. We also build on the work done by leaders such as
Sustainability Accounting Standards Board (SASB) to show how
the financial materiality of different sustainability factors varies
across industries. Our analysis adds a quantitative lens, widening
the scope to the global credit market. We illustrate the results with
a first-of-its-kind materiality matrix across 11 industries.

Contents The need for sustainable fixed income solutions is pressing.

Bonds are in high demand — against a backdrop of aging
Summary 3 populations in search of yield, and geopolitical volatility that has
sparked greater demand for “safe” assets. Many large investors,
Sustainable building blocks 4
such as insurers and pension funds, hold the bulk of their assets
Sovereign sustainability 8 in bonds. Sustainability-related risks are likely to take on greater
importance over the long horizons of such investors. This piece
ESG in credit — builds on a growing body of sustainability-related research at
what’s material? 13 BlackRock in 2019, including our cutting-edge work to pinpoint
the physical risks of climate change across asset classes.
Building sustainable portfolios 17

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Our main findings

•• Environmental, social and governance (ESG) investing •• Using this lens, our research suggests sustainability-
is spreading to all pockets of fixed income markets. related factors explain a meaningful share of the
This includes sectors such as emerging market debt, variation in credit spreads across EM government
which were until recently lagging in ESG data, tools issuers today. Poor ESG performers tend to pay a
and insights. We explain how sustainable investing in higher market premium to issue debt — and vice versa.
fixed income requires a differentiated approach. In Debt markets look to be already pricing in ESG-related
contrast to equities, bond investors’ main ESG focus risks — even as the ties between EM spreads and ESG
is on mitigating downside risk, rather than capturing scores can be swamped by macro forces such as risk-
upside potential. We believe ESG metrics can help off episodes. We see the weight of sustainability in our
identify new risk factors. Yet the diverse spectrum of EM credit analysis rising even further over time as
debt instruments, issuers and maturities calls for regulatory pressures lead issuers to pay greater
targeted analysis in fixed income. attention to sustainability.

•• Innovations in ESG fixed income indexing have •• The financial materiality of different ESG pillars varies
created sustainable building blocks that can form the greatly across sectors. Our first-of-a-kind ESG
core of portfolios. Our research suggests it is feasible materiality matrix for global credit reveals some key
to create portfolios that offer a significant uplift in key differences with standard findings. Among them:
sustainability metrics — including ESG scores and the “E” pillar may have a bigger sway on financial
measures of carbon intensity — while adhering closely institutions than commonly thought. Loans to fossil
to key characteristics of standard bond indexes, such fuel producers expose banks to financial risks in the
as their duration and yield. The history of these transition to a low-carbon economy. We find some
indexes is relatively short. But the early evidence evidence that overweighting exposures to the most
suggests it is possible for investors to adopt them salient sustainability factors by industry can
without sacrificing their risk/return objectives. potentially enhance portfolio performance.

•• We introduce an ESG lens for viewing the •• We show how ESG indexes can be used to make a
sustainability of public debt issuers. This lens provides global multi-asset portfolio sustainable. To illustrate,
a framework to help gauge the performance of 60 we walk through implementing ESG in a hypothetical
issuers on key ESG issues. The goal: to uncover global factor strategy. We replace the fixed income
hidden strengths and vulnerabilities of issuers that and equity assets in the portfolio with sustainable
may not be captured in traditional macro data. The equivalents. This results in a large uplift in key
gauge draws on 39 ESG metrics from the World Bank sustainability metrics. These substitutions have little
— and includes a proprietary big data component that impact on the portfolio’s diversification or risk/return
scrapes thousands of news articles daily to gauge properties, strengthening our conviction that ESG
shorter-term sustainability trends. integration is a “why not?” proposition.

Authors
Michel Aubenas Andre Bertolotti Christian Carrillo
Head of EM Hard Head of Global Head of Macro Asia
Currency Sovereign Sustainable Research Rates and FX research
debt and Sovereign ESG and Data — BlackRock — Alpha Strategies
Sustainable Investing Investment Group

Jessica Huang Katharina Joel Silva

Head — Americas/APAC Schwaiger Portfolio manager —
Platform Strategy and Investment researcher North America Core
Innovation, BlackRock — Factor Based Portfolio Management
Sustainable Investing Strategies Group team in Global Fixed
Income

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Sustainable
building
blocks
Sustainable investing is no longer just a niche strategy
in fixed income. New building blocks such as ESG indexes
make it easier for investors to bring sustainability into
the core of their portfolios.

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Playing catch-up A differentiated approach

The equity market has historically taken the lead when it The application of sustainability-related concerns to
comes to ESG investing. Assets under management in fixed income can draw on many of the conclusions
dedicated ESG funds have been growing at a rapid clip derived from equity-focused research: Strong “E”
over the past decade, yet fixed income strategies today performers tend to have less exposure to environmental
still account for less than one fifth of the assets under risks. High performance on “S” typically signals a
management, according to IMF data as of mid-June. greater ability to attract and retain skilled workers and
See the Gathering momentum chart below. This picture customers. And companies or issuers with strong “G”
is set to change. scores tend to have better risk management than those
with poor “G” scores.
New ESG bond indexes are providing sustainable
building blocks for low-cost strategies — at scale. The Yet we believe applying sustainability to fixed income
green bond market is steadily growing, helping raise requires a nuanced approach that sometimes differs
funds for projects that have positive environmental or from equities. Among the reasons why:
social impact. And improving coverage of ESG metrics
•• Asymmetric risk: Unlike equities, the ultimate value of
allows investors to dig deeper for insights that may be
a bond is capped by its par value. This means there is a
financially material. For example, MSCI’s ESG data
greater focus on downside risk than upside potential.
covered 93% of the issuers in the Bloomberg Barclays
Much of the analysis centers on repayment and
U.S. Credit Index in 2018, versus 75% five years earlier.
default risk. This raises the importance of controversy
scores and other “red flag” ESG measures.
Rating agencies such as S&P and Moody’s are already
integrating sustainability into their ratings frameworks •• Sovereigns require a different approach to credit.
in different ways — and such analysis may take on even Opportunities to engage with issuers (large governments)
greater importance. Some 11 sectors with $2.2 trillion in on ESG issues are typically more limited than on the
rated debt were at risk of credit downgrades due to their corporate level. And macro factors such as interest
exposure to environmental risks such as carbon rates, inflation and safe-haven flows take on greater
transition, a Moody’s analysis in September 2018 importance, making it harder to tease out which ESG
concluded. The electric utilities and the coal sector metrics are financially material.
faced the most immediate risks, with auto makers, oil
•• Securitizations, such as commercial mortgage-
and gas, and commodity chemicals makers facing
backed securities, require analysis of all the
threats on a three-to-five year horizon.
underlying collateral in a deal, not just the issuer.
This may extend to thousands of assets.
Gathering momentum
Growth in ESG funds under management, 2010-2019 •• Use of proceeds: ESG analysis in fixed income is
sometimes more focused on the “use of proceeds” —
$1,000
or what type of project the proceeds of a particular
 Equity
 Fixed income bond issuance are earmarked for — than the
 Mixed allocation sustainability of the issuer itself. Think of a green
Assets under management (billions)

 Other
bond issued by a large oil company with a poor ESG
750
issuer rating. The bond may still qualify as green if its
proceeds are being used to advance sustainability.

•• Engagement: Bond holders do not have the ability to

500 vote or make their views known on ESG-related issues
at annual shareholder meetings. Yet they do have the
opportunity to engage — and potentially influence
behavior — when issuers come to market with new
250 debt or refinance their existing debt.

In this piece we focus primarily on government debt and

corporate credit, which play important roles in many
0 diversified fixed income portfolios. We stress, however,
2010 2012 2014 2016 2018 2019 that ESG investing is coming to all pockets of the fixed
(YTD)
income markets. This applies across geographies and
Sources: BlackRock Investment Institute, with data from IMF, June 2019. Notes: Data asset classes, including mortgages, municipal bonds
are based on IMF staff calculations using Bloomberg Finance data. The year-to-date
(YTD) 2019 data are as of June. The chart shows global ESG-mandated funds only. and cash investing.

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Quality tilt A spectrum of options

Strong performance on key sustainability metrics is Sustainable investing takes many forms and need not
often viewed as a proxy for operational excellence. be an all-or-nothing decision. At BlackRock, we distil
Researchers have found that companies with high ESG client motivations into a spectrum from “avoid” to
scores tend to have a lower cost of capital, higher “advance.” See the Avoid and advance graphic below.
profitability and a lower exposure to tail risks. See
•• “Avoid” strategies involve the elimination of certain
Foundations of ESG Investing in the July 2019 Journal
issuers or sectors that are associated with increased
of Portfolio Management, for example.
ESG risk or which violate the asset owner’s values.

Our analysis suggests that — as in equities — ESG may •• “Advance” strategies focus on increasing exposure to
serve as a proxy for quality in fixed income. To illustrate, positive ESG qualities to align capital with certain
we examined the top and bottom quintile of bonds by behaviors or target specific “E” or “S” outcomes.
ESG score in the European credit universe (the ICE
BofAML Euro Corporate Index), using MSCI’s ESG data. In fixed income, impact investing can include specific
As of mid-2019 the bottom quintile of bonds (poorest mandates such as green bonds (see page 16). We also see
ESG performers) traded at a spread around 25 basis potential in markets that may have been overlooked by
points (bps) higher than the top quintile. In other words, impact investors. Take U.S. agency mortgages, which
poor ESG performers typically must compensate made up almost one third of the Bloomberg Barclays U.S.
investors with higher spread premiums — and vice versa. Aggregate Bond Index as of mid-2019. Here, we see room
to focus on the “S” — through exposures to programs
This implies that simply excluding issuers with the that promote access to credit, help underserved
lowest ESG scores from a bond portfolio may result in a populations and foster community development.
tilt to lower-risk — and lower yielding securities. Might
this lower a portfolio’s returns over time? Our research Similarly, the U.S. municipal bond market is increasingly
suggests not. We studied the performance of the euro in the spotlight of ESG investors. We advocate a focus
corporate index referenced above over the past three on issuers who excel in terms of environmental
years. The top quintile of ESG performers outperformed stewardship, social impact and the quality of policy
the bottom quintile by around 50 bps cumulatively, decisions and implementation. We estimate some one
despite its lower average yield. This bolsters our third of issuance in the U.S. muni market as of mid-2019
conviction that a tilt toward stronger ESG performers in maps to the United Nations Sustainable Development
fixed income need not entail sacrificing return Goals (SDGs) — an increasingly important framework for
objectives. See page 7 for more. guiding capital toward promoting a sustainable future.

Avoid and advance

Sustainable investing styles

Avoid
Motivation
Advance

ESG
Approach Screened Impact
Broad Thematic

Remove specific Contribute to

Invest in securities
companies/industries Pursue specific E, S G or measurable positive
Objective based on overall ESG
associated with SDG issues outcomes alongside
performance
objectionable activities financial returns

Measurable contribution
Key Definition of and financial ESG data sources; Broad versus
and reporting toward
considerations impact of screens active risk taken specific exposures
outcomes

ESG benchmarks; Environmental

Screening out producers Specific green bond
active strategies focus (low carbon or
Examples of weapons, fossil fuels or renewable power
overweighting strong renewable energy);
and/or tobacco mandates
ESG performers social focus (diversity)

Sources: BlackRock Investment Institute and BlackRock Sustainable Investing, October 2019. Note: For illustrative purposes only.

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Beyond niche Trade-offs

ESG uplift of hypothetical optimized credit portfolio
Sustainable investing is no longer a niche strategy in
9 90%
fixed income. New building blocks such as ESG indexes
make it easier for investors to build sustainability into  ESG score
 % Uplift
their portfolios. Our previous work suggests these
strategies may offer similar risk and return properties to 7 60

ESG score
traditional benchmarks — with a meaningful uplift in

% Uplift
ESG outcomes. See Sustainability: the future of
investing for details. This is why we see ESG investing
5 30
evolving from a “nice to have” to a “must have” story.
ESG indexes are likely to become strategic benchmarks
for many investors over time, in our view.
3 0
The various approaches to ESG index investing include: 0 0.05 0.1 0.15 0.2 0.25
% Tracking error
•• Baseline screens that eliminate companies (or issuers)
that pose certain risks or violate an investor’s values. Source: BlackRock Investment Institute, with data from MSCI, October 2019. Notes: The
above is based on a simulation that aims to maximize a hypothetical credit portfolio’s ESG
•• Combining baseline screens with a focus on relatively score. BlackRock takes the constituents of the Bloomberg Barclays U.S. Corporate Index and
performs a standard mean variance optimization for each given tracking error, using MSCI
strong ESG performers. This can be done by excluding ESG scores (1-10 scale). The orange line represents the average ESG score of the optimized
all securities that fall below a cut-off ESG score. index. The “% uplift” bars show the percentage gain in average ESG score relative to the
parent index. This does not represent an actual portfolio, or fund managed by BlackRock or
•• Leveraging optimization to maximize a portfolio’s investable product, nor is it a recommendation to adopt any particular investment strategy.
weighted-average ESG score while closely tracking Indexes are unmanaged and used for illustrative purposes only. They are not intended to
be indicative of any fund or strategy’s performance. It is not possible to invest directly in
the properties of its traditional parent index. an index. The analysis is based on a hypothetical simulation and assumes no changes in
external factors or transaction costs. It is not indicative of actual or future returns.
In the equity market, the first two of these approaches
could lead to material “tracking error,” or deviations in New tools for EM investors
performance relative to parent indexes. Yet we find this
In the emerging market debt space, it has been just over
is less the case for bonds. Why? Macro risks such as
a year since investors have had access to a new set of
interest rates make up the bulk of total risk in fixed
ESG indexes launched by JPMorgan — the fruit of a
income. Issuer over- or underweights are less impactful
collaboration with BlackRock. These indexes reweight
to total risk than in equities. As a result, we believe fixed
EM exposures based on ESG scores, as well as excluding
income investors need not sacrifice their yield,
the bottom quintile of ESG performers.
diversification or return targets under such approaches
to ESG bond indexing.
The new ESG benchmarks would have produced
risk-adjusted returns in line with their traditional
What about the optimization approach? We illustrate
counterparts over the past five years, according to
the potential trade-offs of integrating sustainability by
J.P. Morgan analysis that relies on back-tested data.
constructing hypothetical credit portfolios designed to
Example: an annualized return over the period of 5.7%
track the Bloomberg Barclays U.S. Corporate Index.
for the JESG EMBI Global Diversified Index, versus 5.6%
The goal: to maximize the overall ESG rating for a given
for the JPMorgan EMBI Global Diversified Index. The
tolerance of active risk, while matching the duration, credit
ESG benchmark also exhibited slightly lower volatility
quality and sector weights of this parent benchmark.
over the period (4.2% versus 4.4%). It is early days to
We also introduced a yield constraint: requiring the
clearly point to a trend. This lower volatility could be
hypothetical portfolios’ average yield to be equal to or
attributed to the ESG benchmark’s “quality bias:” the
greater than the parent index. What we found: It was
exclusion and/or reduction in weight of higher-yielding
possible to generate an uplift of more than 50% in a
and often more volatile index constituents.
hypothetical portfolio’s weighted average ESG score
with a tracking error of just five basis points relative to
To be sure, this “quality bias” means that ESG exposures
the parent benchmark. Relaxing the tracking error to
— in EM debt and elsewhere — may underform in “risk
10 basis points resulted in a 69% ESG score uplift.
on” periods when lower-quality market segments lead
See the Trade-offs chart on the upper right.
performance. Yet the early evidence on ESG index
performance bolsters our conviction that sustainable
Bottom line: Our work suggests investors can
investing should not be viewed as an exercise of trading
potentially boost the ESG score of a credit portfolio even
returns for better ESG outcomes.
more than in an equity portfolio — with less active risk.

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Sovereign
sustainability
We introduce an ESG lens for viewing the sustainability
of government bond issuers and explore the relationship
between ESG performance and bond spreads.

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An ESG lens for governments Ingredient selection

Credit analysis of government debt has traditionally Overall, we see three key drivers that can influence an
focused on macroeconomic indicators such as debt-to- economy’s long-term standing from an ESG viewpoint:
GDP ratios and other measures of debt sustainability.
1 How do the issuer’s actions and policies impact the
Other important factors include the issuer’s current
environment and how exposed is it to climate risk?
account position, the health of its financial sector and
its willingness to pay — or willingness to meet its debt 2 How is the issuer investing in its citizens?
obligations. A slew of metrics related to the latter —
3 How effectively is the issuer governing its people?
ranging from political stability to government
effectiveness — have long been viewed as important
We used these overarching principles to guide the
markers of credit risk by bond investors. Such measures
selection of 39 underlying indicators — all from the
are captured in the “G” of ESG.
World Bank’s new ESG data portal — to provide a
holistic view of each public issuer’s sustainability. See
But can the addition of a broader ESG lens enhance
the Under the microscope graphic below for a sample of
our understanding? This has historically been tough to
the individual components under each E, S and G pillar
prove — at least for developed economies. The reason:
— for the full list. The rich set of World Bank ESG data
The relationship between sustainability metrics and
allows us to drill down on metrics such as renewable
government bond spreads can often be drowned out by
energy output and exposure to extreme weather such as
macro factors that are more financially material. Think
droughts and floods (E), female labor force participation
of moves in interest rates and inflation, and swings in
and fertility rates (S), as well as measures of the rule of
risk sentiment that trigger flights into — and out of —
law and corruption (G).
government debt.
Through this lens, we seek to understand vulnerabilities
For this reason we investigated an alternative approach. and management of sustainability issues that may not
Rather than mining historical data in an attempt to be captured by traditional economic indicators.
tease out which sustainability-related factors were most We performed this exercise for 60 developed and EM
financially material, we look to the UN Sustainable debt issuers. The underlying indicators were used to
Development goals (SDGs) to help identify key factors formulate scores for each of the three key pillars: E, S
tied to the sustainability of a public debt issuer. The and G. An equal-weighted combination of the three
SDGs are a set of 17 goals — ranging from poverty pillar scores provides an overall ESG score for each
reduction to clean energy to sustainable cities — that market.
seek to create a more sustainable world by 2030.

Under the microscope

Selected components of a government debt sustainability lens, 2019

Environmental Social Governance

•• Electricity production •• Fertility rate •• Control of corruption

from coal sources •• Income share held •• Government effectiveness
•• Renewable electricity output by lowest 20% •• Political stability and absence
•• Annual freshwater withdrawals •• Access to electricity of violence/terrorism
•• Droughts, floods, •• School enrollment •• Regulatory quality
extreme temperatures •• Net migration •• Rule of law
•• Mean annual exposure •• Share of seats held by women •• Voice and accountability
to air pollution in national parliaments •• Ease of doing business
•• Natural resources depletion •• Mortality rate •• Government expenditure
•• Population density (under five-years old) on education
•• CO2 emissions per capita •• Poverty rate

Source: BlackRock Investment Institute and World Bank, 2019. Notes: The table shows a subset of the 39 World Bank indicators used in the government debt sustainability gauge.
Other “E” components are: energy intensity (ratio of energy output to GDP), net greenhouse gas emissions, terrestrial and marine protected areas, hot days, cold days (below
freezing), number of days with rainfall above 50mm, Other “S” components: ratio of male to female participation rate, share of individuals using internet, life expectancy at birth,
share of children in employment, deaths by communicable diseases and malnutrition, prevalence of undernourishment and prevalence of overweight (population share). For
definitions of these World Bank indicators see the following site: http://datatopics.worldbank.org/esg/framework.html

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Data: moving, fast and slow

It takes a long time for a government to improve its ESG Scoring sustainability
fundamentals in a meaningful way. Material gains in
education and health metrics, for example, can take Here is how we explored scoring public debt
years — if not decades. The same goes for shifting an issuers on their sustainability credentials:
economy’s energy mix to renewables. Many of the
sustainability metrics we watch are inherently slow- Raw scores: Rebase each of the 39 World Bank
moving, and some are reported only annually. indicators on a 1-10 scale. Higher scores indicate
positive performance.
To compensate for the slow-moving nature of these
indicators, we explored a proprietary big data approach Pillar scores: Calculate individual scores for
to track shorter-term progress on sustainability. This each of the Environmental (E), Social (S) and
involves sorting through thousands of news articles and Governance (G) pillars by taking an average of
measuring the frequency of keywords related to each the indicators under each pillar.
ESG pillar. These words are tagged for positive and
negative content. Examples of the former: renewable Combined ESG score: Take an average of the
(E), literacy (S) or anti-corruption (G). The latter includes E, S, and G pillar scores, weighing the three
emissions (E), conflict (S) and bribery (G). A higher pillars equally.
sentiment score means that positive content outweighs
negative content. This can help reveal trends not yet Sentiment score: Calculate a sentiment score
visible in slow-moving official data. (1-10 scale) daily for each E, S and G category
and market, based on Bloomberg newswire
For example, a strong sentiment score offsets some of headline and story content.
India’s ESG weakness based on World Bank data alone.
The reason: our text mining has been picking up a high Final score: Compute a final score: using
frequency of keywords such as “solar” in news articles, this calculation: 0.8*combined ESG score
as India gradually shifts toward renewable energy and score+0.2*sentiment score
away from heavy reliance on coal. See the map below for
rankings by quintile. See the map below for the outcomes of the
markets we analyzed.

Around the world in sustainability

Rankings by quintile in government debt sustainability gauge, October 2019

 Top 12
 13-24
 25-36
 37-48
 Bottom 12 NO SE FI
CA DK DE RU
UK LT
HU CZ
IE BE PO
UA
NL SI KZ
FR AT SK
TK
RS HR
US PT ES RO
CH IT LB CN KR JP
GR
IL
MX EG
DO IN
TH PH
PA VE NG
LK
CO MY
SG
EC
ID
PE BR

AU
CL ZA
AR UY
NZ

Sources: BlackRock Investment Institute, with data from Bloomberg and World Bank. Notes: The chart shows rankings of government debt issuers as of October 2019, from an
ESG perspective. Our gauge divides 39 World Bank development indicators into E (environmental), S (social) and G (governance) pillars. These equal weighted pillars make up
80% of a market’s sustainability score. The remainder of the score comes from a proprietary text analysis of Bloomberg news articles. We measure the frequency of around 125 key
words related to sustainability (across the three pillars) for each issuer on a daily basis. A high score means that the frequency of words with a positive association to sustainability
outweighs that of negative ones. Rankings are bucketed into quintiles. High rankings indicate positive performance on ESG criteria. See page 9 for the underlying components of the
index. See pages 9-10 for the methodology, including the sidebar above. For illustrative purposes only.

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Putting the ESG lens to work Key drivers

Estimated drivers of hypothetical EM credit model, 2019
What’s the relationship between ESG performance and
100%
government bond spreads? Our sustainability gauge was  ESG
not designed with financial materiality in mind. Yet we
found preliminary evidence that our lens can reveal some  Vulnerability
insights into the variation in credit spreads across EM indicators
government issuers.

Weight
50  Government
Our starting point to investigate was a hypothetical finance
government bond pricing model. This included drivers  External payments
such as economic structure (GDP growth), government and debt
finance (debt/GDP ratios) and vulnerability indicators  Credit rating
(adequacy of foreign reserves). See the sidebar below for
further details. We added our gauge to this model and  Economic
0
structure
attempted to find out what proportion of the variation in Five-year 10-year 30-year
bond spreads across EM issuers — and various Source: BlackRock Investment Institute, with data from Bloomberg, Moody’s and World Bank,
maturities — could be explained by each driver. October 2019. Notes: We constructed a hypothetical credit model to explain the relative
importance of common drivers of bond pricing across all the EM government issuers in the
sovereign sustainability gauge described on pages 9-10. We perform this exercise for 5-,
We performed this analysis for maturities ranging up to 10- and 30-year maturities. The model uses a technique called quadratic optimization to
30 years. The key finding: ESG performance — proxied adjust the weights of the six key drivers to best explain the variation of credit spreads across
by our sustainability gauge — explains up to 25% of the EM issuers as of October 2019. The six drivers are explained in the sidebar at left. We use our
sustainability gauge as a proxy for ESG performance. Note that there are inherent limitations
variation in EM sovereign spreads today. See the Key to such models. Not all relevant factors may be included. Other factors such as geopolitics
driver chart. For five-year debt, ESG was the most may also impact debt prices. For illustrative purposes only.
powerful driver in our model. And for all maturities we
examined, ESG had greater explanatory power than
traditional credit ratings by agencies.
A key driver
The addition of ESG resulted in the weight of credit
agency ratings in the model shrinking to 10% or lower.
This compares with as high as 35% in a model that did
not include sustainability. How to explain this result?
Key drivers of hypothetical Our sustainability gauge may be capturing much of the
government bond pricing model subjective judgment by rating agencies around the “G” in
ESG — on good governance and willingness to pay — that
Credit rating is not fully reflected in traditional economic data. Markets
This reflects the practical reality that many institutional may not have been assessing these risks explicitly. But
investors define their holdings of EM debt based on they likely were implicitly outsourcing part of this
published credit ratings from international agencies.
judgment to credit rating agencies. We believe increasing
Economic structure regulatory demands to increase oversight on ESG risks
Indicators capturing economic prosperity, resilience will lead to a further increase in the weight of such factors
and growth trends, such as nominal GDP, growth, in our EM credit analysis.
investments and savings.

ESG The results above are based on a snapshot as of early

Our sustainability lens based on World Bank data and 2019. We also backtested the simple hypothetical model
sentiment scoring. using historical data, focusing this time on seven- to
External payments and debt 10-year maturities. What we found: markets have been
Indicators measuring external liabilities, balances and giving a material weight to sustainability-related factors
liquidity such as FX reserves and foreign debt/GDP ratios. in their pricing of EM debt for at least the past five years.
Government finance The relative importance of the various building blocks in
Indicators capturing government budget flexibility, our model — including ESG — has been surprisingly
balance sheet strength and potential off-balance sheet steady over time. There is more work to be done in
liabilities such as debt/GDP ratio and fiscal deficit. understanding the link between ESG and public debt
Vulnerability indicators markets. This includes drilling deeper to find which ESG
Reserve adequacy, market access and leading metrics are most financially material: an exercise we
indicators of sovereign crises such as FX reserve apply to global credit markets on page 14-15. Yet these
ratios, asset-liabilities and credit growth. early results give us greater confidence that ESG is a
material driver in emerging market debt.

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Kicking the tires Moving together

EM credit spread vs. average ESG risk, 2018–2019
Can the addition of an ESG lens help enhance returns
in an EM debt portfolio? We backtested a simple 240 48
hypothetical strategy: buying all the EM sovereign  EM credit spread
bonds that were “cheap” in our ESG-integrated  ESG risk

Credit spread (basis points)

sovereign credit model and rebalancing twice a year 210 47
with the most recently available ESG and macro data.

ESG risk (index)

The results can be seen in the Sustainable returns?
chart below. An equal-weighted hypothetical portfolio 180 46
made up of these cheap bonds outperformed over the
five-year period starting in June 2014 — not just against
a standard EM debt benchmark (the JPMorgan EMBI 150 45
Global Index) but also against an equal-weighted
portfolio of all the EM bonds we analyzed.
120 44
The period included a significant EM sell-off in 2018,
Sept. 18 Dec. 18 Mar. 19 Jun. 19 Sept. 19
as well as a rally in the first half of 2019. The hypothetical
Past performance is not a reliable indicator of current or future results. Sources:
ESG portfolio exhibited slightly higher volatility than the
BlackRock Investment Institute, with data from Bloomberg and RepRisk, October
EM benchmark, but greater risk-adjusted returns over 2019. Notes: The chart shows the average credit spread of all investment grade rated
the period, we found. sovereign names in the JPMorgan JESG EMBI Global Diversified Index (weighted by
market cap), plotted against the average ESG risk of those sovereign names (again by
benchmark weight), We use RepRisk ESG scores as a proxy for ESG risk, lagged by three
More work is needed to validate these results. Part of the months. RepRisk uses a 1–100 scale, with higher scores indicating a poor ESG profile.
ESG portfolio’s outperformance came from its avoiding
exposure to Argentina, which faced another economic
crisis in 2019. Yet overall, we see this as encouraging
High ESG score = tighter spread
evidence that ESG data can be used to help identify Other work we have done using ESG metrics from
“cheap” bonds in the EM sovereign debt space, with external providers reinforces the view that sustainability
potential to enhance risk-adjusted performance. is a relevant concern for sovereign debt. A key conclusion:
Credit spreads are negatively correlated with ESG scores.
Sustainable returns? In other words, issuers with poor ESG characteristics
Backtested returns of hypothetical portfolio, 2014–2019 must compensate investors with higher yields. The chart
50% above shows this trend for investment grade rated EM
issuers. Note that this relationship is not perfect; the
paths of EM sovereign spreads and ESG scores can
 Hypothetical sustainable EMD portfolio decouple during sharp sell-off periods. One such example
 Equal-weighted EMD
 EMD benchmark
was August of 2019, when an escalation in global trade
tensions and a crisis in Argentina hit EM assets. In such
periods, overall risk appetite and global macro conditions
25
can have an overwhelming effect on EM bond spreads.
This can cause market pricing to become temporarily
de-anchored from fundamentals such as ESG.

In our view, this speaks to the need for investors to

consider fully integrating ESG considerations into their
0 overall investment process. ESG needs to be considered
2014 2015 2016 2017 2018 2019 in combination with economic fundamentals and the
Past performance is not a reliable indicator of current or future results. Source: market backdrop. In the EM world, a noticeable
BlackRock Investment Institute, with data from Bloomberg, Moody’s and World Bank. improvement in ESG data coverage over the past couple
Notes: This analysis focuses on the seven- to 10-year bonds of all the EM issuers in our
60-issuer sovereign sustainability gauge. Our six-factor hypothetical sovereign credit of years has made this task easier. Expanded and high-
model (see page 11) generates a “fair value” for each bond analyzed. The orange line frequency datasets, increasingly leveraging big data
shows the performance of a hypothetical strategy that buys all the bonds in our universe techniques such as text mining, allow for a systematic
that are cheap relative to this fair value assessment (see page 11), rebalancing the
portfolio each six months. EM benchmark refers to the JPMorgan EMBI Global Index. deployment of ESG information and its integration in
The equal-weighted line takes a simple average of the performance of all the EM bonds investment processes. We find this helps active EMD
analysed. Returns do not reflect any management fees, transaction costs or expenses. investors to complement ESG analysis that used to be
Backtested performance is hypothetical, simulated and is not indicative of actual or future
returns. It is also developed with the benefit of hindsight, has inherent limitations and skewed toward a qualitative approach.
invariably shows positive rates of return. For illustrative purposes only.

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ESG in credit
– what’s
material?
We show which ESG characteristics we see as most
financially relevant across industries in global credit.
Our early work shows potential to improve risk-adjusted
performance by tilting toward such exposures.

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Measuring materiality What’s material?

Materiality of E, S and G in equities & credit, 2015–2019
What are the ESG factors that really move the dial
50%
when it comes to financial performance? This involves
 Environmental
digging below headline scores. For example, some  Social
environmental factors such as water management are  Governance

Relative importance
key drivers in the materials sector — but of little-to-no
relevance for financials. Governance factors such as the
strength of risk controls lie at the heart of past financial 25
crises — and are the key driver for banks.

What do we mean by materiality? It is the connection

between exposure to given sustainable properties and
returns or risk. Organizations such as the Sustainability 0
Accounting Standards Board (SASB) and Task Force on Base case Equities Bonds
Climate-related Financial Disclosures (TCFD) have been
Source: BlackRock Investment Institute, with data from MSCI, Sustainalytics and
leaders in identifying and communicating the Refinitiv, October 2019. Notes: The chart shows BlackRock’s estimate of the financial
importance of materiality-based analysis, particularly materiality (or relative importance, in percentage terms) of E, S and G factors in driving
performance in the equities and global credit market over the five-year period through
on environmental and social factors. Much of our
June 2019. We use regression analysis to estimate the relationship between each
understanding of which sustainability metrics are most ESG pillar and monthly excess returns over the period. The “base case” is derived from
relevant is based on studies of equities. Yet companies BlackRock’s numerical interpretation of the Sustainability Accounting Standards Board
(SASB)’s “materiality map.” Equities analysis is based on the MSCI World Developed
issue a broad range of other securities beyond common
index. Bonds are based on credit spread returns of the Bloomberg Barclays Global
stock. We set out to develop a “materiality matrix” for the Aggregate credit index. For illustrative purposes only.
global credit market to get better insights on how bond
investors can integrate ESG characteristics. Our
starting point: six broad sustainable categories that
Defining the base case
BlackRock sees defining the E, S and G properties of We applied our fixed income analytics and quantitative
companies. See the graphic below. tools to measure the connection between these six
categories and variations in global credit spreads. This
helped us to see which of the three overarching ESG
Defining sustainability pillars best explained global corporate bond returns
Six categories of BlackRock’s sustainability framework since 2015, after managing for common risk factors
such as duration, credit ratings, country and currency.
Natural resource For this analysis, we considered the ESG characteristics
E Low carbon transition E
management
of each parent issuer and analyzed the performance of
• Carbon emissions • Energy management its most liquid bond. This built on a similar analysis we
• Clean technology • Water & wastewater have performed for equities.
management
• Waste & hazardous
Our point of comparison for both: SASB’s assessment
materials
management of which sustainability topics are likely to have material
impacts on the financial condition or operating
External stakeholder Internal stakeholder
S
management
S
management
performance of companies in a particular industry.
We converted SASB’s “materiality map” into numerical
• Customer relations • Talent management weights for BlackRock’s six sustainability categories —
• Community relations • Inclusion & diversity and the three main ESG pillars. We use this as the “base
• Workers’ rights case” for comparison against our own materiality matrix.
The high level results are shown in the What’s material
Corporate culture chart above.
G Board quality G
and management

• Board effectiveness • Audit, tax & risk The key takeaway: We find much higher materiality for
• Board independence management the “G” in ESG than the base case, both in equities and
• Business ethics credit markets. Our analysis also finds a moderately
• Ownership & control lower role for “E” and “S.” Overall, our research suggests
Source : BlackRock Investment Institute and BlackRock Sustainable Investing, each of the three ESG pillars are of roughly equal
November 2019. Notes: The graphic shows the six main categories of BlackRock’s ESG importance for both credit and equities markets. Yet
framework, with 15 underlying descriptors. These are informed by more than 300 key
performance indicators (KPIs) taken from ESG data providers, specialized data sources variations across sectors reveal key insights on the
and internal data developed by BlackRock. materiality of pillars. See the following page for details.

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Sector spotlight Sustainable credit

Hypothetical ESG credit strategy backtest, 2015–2019
To gain greater insight into our results on materiality,
3%
we ran the analysis at the sector level. The results are
 Credit benchmark
shown in the materiality matrix below. Two highlights:  Sustainable credit
2
Financials — We found a meaningful link between
financials valuations and our two “E” categories. Since
bank operations themselves have little exposure to 1
environmental factors, what could be affecting
valuations? We believe investors are considering the 0
fossil fuel and green energy exposure in banks’ loan Total return Volatility
books. For example, banks’ loans to fossil fuel producers
may be at risk of future losses in a scenario in which Past performance is not a reliable indicator of current or future results. Sources:
carbon taxes are introduced. BlackRock Investment Institute, with data from Bloomberg, MSCI, Sustainalytics and
Refinitiv, November 2019. Notes: The chart shows annualized total returns and volatility of a
hypothetical ESG global credit portfolio indexed to the Bloomberg Barclays Global Corporate
Utilities — Environmental risks such as exposure to Index, backtested over the period January 2015 through June 2019. The sustainable
extreme weather pose tangible risks to the electric version optimizes the exposures of this parent index, seeking to maximize exposure to the
utilities sector, as we demonstrated in Getting Physical sustainability metrics that BlackRock finds most material for each industry (based on the
materiality map shown below), while matching key benchmark characteristics (duration,
of April 2019. Yet we found the pricing of utilities’ country and industry weights, yield to maturity and credit ratings). Total returns are net of
corporate debt in recent history does not reflect this, as trading costs. Estimated trading costs include two components: a fixed cost (bid-asks) and
the matrix shows. Instead, it has been more sensitive to a variable cost depending on trade size. Backtested performance is hypothetical, simulated
and not indicative of actual or future returns. It is developed with the benefit of hindsight, has
measures of corporate governance. inherent limitations and invariably shows positive rates of return.

How might an investor use the information in a financial These results are based on a limited four-year time
materiality matrix? We see potential use as a tool for period, but we find them encouraging. The backtested
security selection: overweighting issuers with exposure hypothetical portfolio modestly outperformed its global
to the sustainability metrics that we find are most credit benchmark, with similar volatility. See the
relevant for each industry. We tested this theory with a Sustainable credit chart. It offered above-benchmark
hypothetical global credit portfolio. We performed an exposure to almost all of our key sustainability metrics.
optimization on the Bloomberg Barclays Global Credit
Index that sought to maximize such sustainability Bottom line: We find some early evidence that a deeper
exposures while matching the parent index’s country understanding of materiality can help deliver a financial
and industry weights, duration, yield and credit ratings. edge in credit markets. We also see it as a useful tool for
engagement, arming investors with the information to
question companies about areas of perceived weakness.

Material world
Financial materiality of BlackRock ESG pillars in global credit, 2015–2019
y
C o t ion r

r
s t n s ar

te
re

ls
e

le me

ls

ls

s
re m

r ia

ta
ca
ia

om

es
ia
sc u

ap u

gy

es
nc

lth

st
s

er
di on s

iti
ec
er

h
du
na

al
at
ea

t il
c

l
En

Re
C

Te

Te

Negligible Low Medium High

In

M
Fi

   

Low carbon transition

E
Natural resource management

Internal stakeholder management

Pillar S
External stakeholder management

Board quality
G
Corporate culture and management

Source: BlackRock Investment Institute and BlackRock Sustainable Investing, with data from Bloomberg, MSCI, Sustainalytics and Refinitiv, November 2019. Notes: The chart shows
BlackRock’s assessment of the financial materiality of key ESG pillars in the global credit market over January 2015 through June 2019. We use regression analysis to estimate
the strength of the relationship between each pillar and monthly excess returns (ex duration effects) of 11 credit sectors over the period. “Negligible” indicates that there was little
relationship between a particular ESG factor and monthly returns over the period studied; “high” indicates a relatively strong relationship. Note that this analysis is based upon a
limited historical period and the materiality of sustainability-related factors may change over time. For illustrative purposes only.

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Growing green bonds “Dark green” bonds attract our highest rating: these are
projects that BlackRock sees as most likely to help put
the world on a long-term track toward a zero-carbon
The green bond market is maturing. Outstanding economy. Examples include projects in renewable
issuance of green bonds, which help finance projects energy and electric transportation. Lighter shades of
with environmental benefits, hit $590 billion in August, green include green building projects that include less
almost eight times the size of the market in 2015, stringent energy efficiency standards.
according to IMF data as of October.
An “off-scale” category covers projects that we
BlackRock has helped devise the Green Bond Principles consider ineligible for green bond status. These include
(GBP), a set of voluntary guidelines that aim to foster improvements to fossil fuel infrastructure, such as
transparency and integrity of the market. The four technologies aimed at reducing the environment impact
components of the GBP form BlackRock’s minimum of coal burning. Such projects may have clear
requirement for a green bond label: declaring the environmental benefits. Yet any intervention that
eligible project categories up front, working to establish prolongs the useful life of brown (fossil fuel) assets is
environmental sustainability objectives, reporting at not consistent with an eligible green project within best
least annually on the measured use of proceeds, making market practice for green bonds, in our view. Nuclear
sure they are ring-fenced for the projects declared. energy projects are also excluded due to the potential
What qualifies as green? The GBP recognizes 10 broad environmental impacts of radioactive waste — despite
categories, ranging from renewable energy to energy their zero-carbon benefits.
efficiency and sustainable water.
Do green bonds trade differently than their standard
Yet qualifying for green bond status is more than just counterparts? We studied the green bonds of 40 major
a binary decision. BlackRock has developed a new rating U.S. dollar and euro issuers — government and
system that rates green bonds according to their corporate. What we found: There was no material pricing
“greenness” — or the impact of the proceeds use. While difference between green and non-green bonds as of
various “shades of green” spectra have been used more October 2019. Credit risk was identical, as was liquidity.
broadly to compare environmental impacts across a We found no material difference in bid-offer spreads.
range of investments, we find the concept useful to Overall, this strengthens our conviction that green
compare among the narrower set of investments that bonds are coming of age — and are no longer just a
qualify under the GBP. See the Shades of green chart. niche strategy for impact investors.

Shades of green
BlackRock’s green bond rating categories, 2019

Very light green Light green Medium green Dark green

Projects that yield only Projects that yield Projects that yield Projects that BlackRock
marginal improvements improvements over baseline improvements over baseline determines are most likely
over baseline energy energy consumption and energy consumption and to help put the world on
consumption and CO2 CO2 emissions, but are not CO2 emissions, and show the long-term path to
emissions. yet aligned with long-term some signs of alignment with decarbonization.
decarbonization. long-term decarbonization.

Examples Examples Examples Examples

• “Sustainable” plastic • Non-electrified • Green buildings • Renewable energy
packaging public transit (stringent standards) • Electric transportation
• High speed mobile networks • Environmental • Hybrid electric vehicles • Smart meters
• Green buildings with silver remediation • Waste water treatment
LEED rating • Adaptation projects
(e.g. sea walls)

Share of index Share of index Share of index Share of index

2% 33% 17% 48%

Source: BlackRock Investment Institute, with data from Bloomberg, November 2019. Notes: For illustrative purposes only. Share of index refers to the share of green bonds under
each BlackRock rating category in the Bloomberg Barclays U.S. Aggregate Index as of June 2019.

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Building
sustainable
portfolios
We demonstrate how adding fixed income ESG
exposures to a diversified multi-asset portfolio
can meaningfully increase its sustainability without
sacrificing return objectives.

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Making multi-asset sustainable Sustainable substitutions

Makeup of a hypothetical global factor portfolio, 2019
Recent advances in ESG fixed income indexes have
100%
deepened the toolkit for multi-asset investors. Fixed
income allocations often comprise more than half of
such portfolios. This means equity-focused ESG  DM equity
allocations alone can only do so much to improve the

Sustainable
sustainability profile of such portfolios.

These indexes can help boost the average ESG score of 50

 EM equity
a portfolio and reduce its carbon footprint. The recent
availability of sustainable indexes in emerging market
debt is a particularly important step forward: Many EM  DM credit
 EM sovereigns
debt issuers are significant emitters of greenhouse
 DM sovereigns
gases. Their “carbon intensity” is therefore much higher
 Other
than other asset classes. Yet new sustainable EMD
0
indexes allow for a dramatic reduction in the carbon
emissions embedded in such exposures. See the Capital Risk
allocation contribution
Curbing carbon chart below.
Source: BlackRock Investment Institute, October 2019. Notes: The chart shows the
allocations of a hypothetical global multi-asset portfolio. DM sovereigns include
We used a hypothetical global multi-asset strategy inflation linked debt. DM credit includes both investment grade and high yield debt.
to illustrate how ESG indexes can be utilized to integrate Other includes property, commodities and cash. Indexes used are: MSCI World ESG
Enhanced Focus Index and MSCI USA Small Cap Extended ESG Focus Index (DM
sustainability into such a portfolio. The portfolio seeks equity), MSCI Emerging Market ESG Enhanced Focus Index (EM equity), JP Morgan
balanced exposures to six key macroeconomic factors, ESG EMBI Global Diversified Index (EM sovereigns), Bloomberg Barclays MSCI US
or persistent drivers of asset class returns: economic Corporate ESG Focus Index and Bloomberg Global HY Sustainable SRI (DM credit),
BAML Global IL Government and Barclays Global Treasury G7 Countries (DM
growth, real rates, inflation, credit, emerging markets sovereigns), FTSE EPRA Nareit Developed (other) and Bloomberg Commodity Index
and liquidity. This translates into a global asset (other). For illustrative purposes only.
allocation that spans large- and small-cap equities,
sovereign debt, credit, commodities and property across The goal of this hypothetical portfolio: to demonstrate a
developed markets and EMs. See the top-right chart. tangible improvement in portfolio level ESG metrics and
a reduction in portfolio-level carbon emissions, while
delivering better diversification than traditional 60/40
portfolios. Fixed income allocations, including emerging
market debt, make up around 60% of the hypothetical
Curbing carbon portfolio. Replacing a portion of this with sustainable
Carbon intensity: standard vs. ESG indexes, 2019
indexes can meaningfully boost the overall portfolio’s
2,500
Metric tonnes CO2/revenues

ESG profile, we found. This came without changing the

2,000  Standard risk-return profile or the need to venture into more niche
 ESG indexes such as green bonds. See page 19 for details.
1,500
Using available sustainable fixed income and equity
1,000 indexes we can substitute the following assets: all equity
exposure, investment grade and high yield credit, and
500
emerging market sovereign debt. This allows us to
0 replace more than 50% of the hypothetical portfolio
EM Global U.S. EM World U.S. small
by market weight (and risk contribution). See the
debt high yield IG equity equity cap equity Sustainable substitutions chart for the portfolio’s
exposures by capital allocation and risk contribution.
Fixed income Equities
Source: BlackRock Investment Institute, with data from MSCI, October 2019. Why not replace 100% of the portfolio with sustainable
Notes: The chart shows the carbon intensity (metric tonnes of CO2 emissions divided assets? For some asset classes, such as property and
by total revenues) of standard equity and bond indexes versus their ESG counterparts. commodities (in the “other” slice of the chart), it is harder
Standard indexes are represented by: JP Morgan EMBI Global Diversified Index,
Bloomberg Barclays Global HY Index, Bloomberg Barclays U.S. Corporate Index, to find substitute assets that offer similar underlying
MSCI Emerging Market Index, MSCI World Index and MSCI USA Small Cap Index. exposures. Green properties, for example, offer such
ESG indexes: JP Morgan ESG EMBI Global Diversified Index, Bloomberg Global HY promise, but remain a niche investment area. Similarly,
Sustainable SRI, Bloomberg Barclays MSCI US Corporate ESG Focus Index, MSCI
Emerging Market ESG Enhanced Focus Index, MSCI World ESG Enhanced Focus Index ESG indexes are yet to come to asset classes such as
and MSCI USA Small Cap Extended ESG Focus Index. developed market inflation-linked debt.

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Our key findings: A different lens

Duration-adjusted ESG scores of hypothetical portfolio
The hypothetical sustainable multi-asset portfolio
retained a similar risk-return profile to its traditional Bond Allocation Duration ESG score
counterpart. It delivered a 20% improvement in the 1-year 50% 0.9 10
portfolio’s overall ESG score — and a carbon intensity 30-year 50% 25 0
Portfolio
almost 50% lower, according to calculations based on A Average ESG score 5
our market-weighted allocations and ESG scores and
carbon data from index providers. Other key findings: Duration-weighted ESG score 0.35

•• Total returns were roughly identical to the traditional 1-year 50% 0.9 0
portfolio over the period studied, which included the 30-year 50% 25 10
Portfolio
global financial crisis and several bouts of volatility in B Average ESG score 5
the period since. See the Drawing even chart.
Duration-weighted ESG score 9.65
•• The replacement of traditional assets with their
Source: BlackRock Investment Institute, October 2019. Notes: For illustrative purposes
sustainable versions did not meaningfully impact the only. The table shows the allocations of two simplified hypothetical portfolios and their
diversification properties of the multi-asset portfolio. ESG scores. ESG scores are on a 0 (bad) to 10 (good) scale. The duration-weighted
ESG portfolio score is calculated by multiplying the duration contribution of each bond
•• The relatively low correlations across asset classes — (duration of the particular bond divided by total portfolio duration) by its ESG score and
which help cushion such a portfolio against episodes summing up these contributions.
of volatility — remained largely unchanged.
Scoring ESG scores
Bottom line: The toolkit for multi-asset investors is How to compare the ESG profile of two sustainable
deepening when it comes to integrating sustainability- funds? The most common approach: taking a market-
related factors. Our work shows how global factor value weighted average of the issuer ESG scores held
investing and sustainable investing can be combined. in a portfolio. This intuitively makes sense — you want to
The resulting portfolio matches returns of its standard allocate more in dollar terms to issuers with better ESG
counterpart while significantly improving upon its ratings and less to issuers with poor ESG ratings. But it
sustainable characteristics. Such portfolios may offer potentially overlooks a key nuance: Unlike equities, fixed
greater resilience in the future as ESG-related risks such income instruments have a maturity date. Longer dated
as the increasing incidence of extreme weather events bonds are more risky; this is why short- and long-term
compound over time. We see this as further evidence of bonds of the same issuer often carry very different
a “why not?” moment in sustainable investing. credit ratings. An ESG-relevant example: The risk of
future carbon regulations is much more material for a
10-year corporate bond than for a short-term one.
Drawing even A potential solution could be for fixed income investors
Hypothetical multi-asset portfolio backtest, 2007–2018 to look at duration-weighted ESG scores for portfolios.
80%
 ESG Let’s see how this might work. Consider two simplified
 Traditional
portfolios. Both have equal-weighted exposure to two
40
bonds: a 1-year and a 30-year. In Portfolio A, they are
Total return

issued by companies with the highest and lowest

possible ESG rating respectively. Portfolio B is a mirror
0
image: see the A different lens chart. Both portfolios
have identical average ESG scores, but very different
duration-weighted ESG profiles. Portfolio B scores much
-40
more highly on sustainability on this measure.
2007 2009 2011 2013 2015 2018
Past performance is not a reliable indicator of current or future results. To be sure, this is an extreme example. The effects of
Source: BlackRock Investment Institute, with data from Bloomberg and MSCI,
November 2019. Notes: The chart shows backtested performance of a hypothetical using a such a methodology on a broad and diversified
multi-asset portfolio from 2007 through 2018. See the previous page for the portfolio would be less stark. We are not arguing that
portfolio’s risk and asset composition. We show a traditional portfolio (non-ESG) this is the definitive approach to calculating a portfolio-
versus its ESG counterpart. The hypothetical ESG portfolio substitutes out standard
(non-ESG) indexes for ESG replacements based on availability of backtested data for level ESG score in fixed income. And we see room to
the latter, as follows: global equities (from 2007), global credit (2007), EM equities further refine this analysis, by incorporating credit
and EM debt (2013). Returns do not reflect any management fees, transaction costs or spreads, for example. Yet we believe this thought
expenses. Backtested performance is hypothetical, simulated and is not indicative of
actual or future returns. It is also developed with the benefit of hindsight, has inherent exercise offers a useful lens for viewing some of the
limitations and invariably shows positive rates of return. For illustrative purposes only. nuances of ESG integration that are unique to bonds.

19 BlackRock Investment Institute | Insights

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BlackRock Investment Institute
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Lit No. BII-ESGINV-FI-1119 283011-1119

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