Want a better bond portfolio? Better think responsibly.

According to a recent study from Barclays, a bond’s risk-adjusted returns stem in part from the environmental, social and governmental (ESG) characteristics of its issuers.

In other words, social and environmental responsibility are performance factors for fixed-income portfolios, says Lev Dynkin, managing director, founder and head of Barclay’s quantitative portfolio strategy group.

“We fully expected that the impact of ESG would be negative,” Dynkin says. “It turned out to be the opposite. We felt like ESG bonds should have higher demand and higher prices, and that they should underperform, but the presence of ESG factors was actually accompanied by small but steady outperformance.”

Barclays says that its study found a “small but positive” impact on returns for bonds issued by entities with high ESG scores as compared to those issued by entities with low ESG scores.

The difference persisted when Barclays used different methods of scoring and ranking companies based on ESG, says Dynkin.

“The performance was not achieved due to excess demand, but because ESG bonds tend to have fewer credit downgrades and experience fewer adverse credit events,” Dynkin says. “We think that portfolio construction should consider ESG ratings as one of the risk factors, specifically in the fixed-income side of the portfolio.”

In it’s research, Barclays used ESG data from MSCI and from Sustainalytics, measuring a 42-basis-point return advantage in high ESG bonds using MSCI’s scoring and a 29-basis-point advantage using Sustainaytics scoring.

Corporate governance was the most impactful factor on investment returns, according to the study, bonds issued by companies with strong governance scores within the MSCI Socially Responsible Indexes outperformed their lower-scoring peers by 82 basis points.

Environmental and social factors had lower impacts, with the social factor bringing the smallest return of all three. Nevertheless, a corresponding Barclays survey of asset managers found that investors were most responsive to environmental factors.

“We think that these high ESG companies are more likely to be protected from additional risks,” Dynkin says. “They increase returns because they’re protected from negative environmental and regulatory impacts. Their good governance and high social ratings may help protect them from strikes or protests.”

Part of the benefit also has to do with the way bonds are traded -- bonds with high ESG scores trade at lower-than-average spreads, and investors interested in ESG are more likely to hold onto their investments over a long term.

High-ESG bonds have not encountered increasing relative valuations over the past eight years, according to Barclays, which implies that their performance gain is not related to buying pressure.

In the MSCI data, there was a 38-basis-point average spread between high and low ESG bonds, while Sustainalytics measured a spread of 35 basis points. The difference also accounted for a one-tick improvement in average credit quality, from A3 to A2.

The study was only able to look back eight years, according to Dynkin, because the ESG ratings systems are still relatively new and have limited data sets.

“This is a young industry and these numeric ratings are relatively recent,” Dynkin says. “We would like to have had a much longer period, but we could only go back to the point where both ratings systems had data for a sufficient number of issuers.”

Dynkin also warns that the outperformance is only present when portfolios are constructed using ESG scoring and ranking, not when negatively screening for ESG characteristics.

“The ranking approach is better because eliminating entire industries or sectors creates systemic risks in the portfolio that may lead to underperformance,” Dynkin says. “Using a ranking system to give a portfolio an ‘ESG tilt’ does not include that systemic risk.”