Credit Quant. 22 October 2018 Research Insights ESG

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1 Insights ESG Credit Quant ESG under the alpha lens We find compelling evidence that ESG research deserves a place in credit investing, as high ESG scores reduce exposure to tail risk and enhance long-term returns. Our "high ESG" bond portfolio shows 8% outperformance versus our "low ESG" bond portfolio. We also find negative returns to be larger and relatively more frequent among bonds from issuers with lower ESG ratings compared with bonds from issuers with higher ESG ratings. Additionally, our data clearly indicates that changes in ESG ratings act as a leading indicator of creditworthiness. Taken altogether, we find ESG screening to be a useful tool for credit investors. Key conclusions After having analysed performance and operational traits across 10,000 EURdenominated bonds, we come to the following key conclusions: Our portfolio with high ESG scores has outperformed the portfolio with low ESG scores by 8% during ; Strong ESG focus leads to stronger resilience during times of crisis; ESG rating changes show merits as a leading indicator of credit risk; and, ESG ratings are largely uncorrelated with credit ratings. ESG holding up in times of crisis Our portfolio of bonds with high ESG scores has generated 8% outperformance over the portfolio with low ESG scores since The outperformance has primarily been driven by stronger resilience during times of high market volatility, especially during the financial crisis and the European debt crisis between 2011 and Higher-rated companies have smaller drawdowns in annual bond returns. The worst annual return for an AAA ESG-rated bond is -16%, whereas the same number for B and CCC ESG-rated companies is as much as -45%. As bond returns have limited upside, and far more downside, we find the risk-mitigating characteristics of ESG ratings to be a very compelling tool in bond portfolio construction. We argue that now is a good time to build a strong ESG exposure, as we foresee increasing macroeconomic headwinds and more volatile markets ahead. ESG ratings a leading indicator for credit ratios We find that companies with high ESG scores have a higher interest coverage ratio, better return on assets, higher FFO/net debt, less volatile revenue and lower net debt/ebitda than the market. More interestingly, ROA, net debt/ EBITDA, the interest coverage ratio and FFO/net debt also tend to improve following an ESG rating upgrade. Despite consistently stronger financial profiles for issuers with higher ESG ratings, we find ESG ratings to be largely uncorrelated with credit ratings, implying that they capture risk factors overlooked by traditional credit analysis. Nordea Markets - Analysts Johan Hallgren johan.hallgren@nordea.com Hugo Fredriksson hugo.fredriksson@nordea.com Elias Porse elias.porse@nordea.com PERFORMANCE VS BENCHMARK 8% 6% 4% 2% -2% -4% Low ESG Source: MSCI ESG and Nordea MEDIAN FFO/NET DEBT 4 2 High ESG MEDIAN NET DEBT/EBITDA 3x 2x 1x 0x IMPORTANT INFORMATION AND DISCLOSURES AT THE END OF THIS REPORT

2 Credit Executive summary Investors, consumers and regulators are all starting to realise the cost of being unsustainable, and focus is increasingly being directed towards ESG factors in credit investing. We find strong arguments for why it makes sense to incorporate ESG into credit investing decisions. Our analysis of investment grade corporate bond portfolios based on MSCI's ESG scores shows that high ESG scores contribute to more stable portfolio returns during periods of high market volatility, which in turn has led to enhanced long-term returns. In addition, we find that ESG trends show merits as leading indicators of creditworthiness. Sustainability and ESG are becoming megatrends ESG on every agenda ESG is rapidly gaining more and more attention from investors, asset managers, asset owners, corporations, regulators and society as a whole. Over 1,700 asset managers have signed up to the Principles of Responsible Investment (PRI), amounting to USD 70tn in AUM, of which USD 30tn is fixed income. By doing this, they are committing to incorporate ESG into their decision-making processes. While ESG is nothing new to credit analysis, the extent to which it is being utilised by fixed income investors and analysts is. If not handled correctly, ESG-related risks can result in substantial financial and/or reputational damage for a company. Changes in regulation can force a ramp-up in capex and squeeze margins. ESG-related governance incidents can result in fines. Child labour scandals can erode brand value and cause lost revenues. Taken altogether, these can make a substantial dent in a borrower's ability to honour its debt obligations. The increasing importance of ESG and sustainability is supported by strong long-term fundamental trends. Regulations are increasing in the ESG realm, ESG-related taxes are on the rise, consumers are becoming more interested in ESG-related topics and consumers are willing to pay a larger premium for "good" products. These factors suggest that there are lasting, or even strengthening, operational tailwinds for companies that do better on ESG metrics than their peers. The severity of the consequences of failing to cope with ESG-related challenges should, by necessity, turn the current ESG trend into a megatrend to which all companies and investors need to adapt. We see consistent outperformance of bonds from companies with high ESG scores during periods of high market volatility ESG holding up in times of crisis Our findings indicate that incorporating ESG factors into the investment decision process is sound course of action. The portfolio of bonds from companies with high ESG scores generated 8% outperformance versus the portfolio with low ESG scores. Outperformance is particularly prominent during times of high market volatility, indicating stronger downside protection. We quantify the effect of ESG in corporate bond investing by constructing portfolio pairs with matching risk characteristics (duration and credit rating) but vastly different MSCI ESG scores. We then measure the spread in cumulative total return between these portfolios over time. This spread can be interpreted as the ESG factor. Our universe is investment grade EUR-denominated corporate bonds. The macroeconomic strength surprised most market participants during 2016 and 2017, and market volatility reached the lowest levels seen in a long time. Strong ESG performance did not yield any outperformance during that same time period, as the low-risk traits associated with strong ESG performance were not sought after by the market. However, tailwinds are slowly but surely turning into headwinds, and we foresee a further pickup in macroeconomic headwinds with increased market volatility as a result. We think that such a scenario bodes well for a performance rebound for bonds with solid ESG ratings. In short, we argue that now is a good time to get exposure to ESG in credit portfolios. 2

3 Credit HIGH ESG OUTPERFORMS LOW ESG DURING TIMES OF HIGH MARKET VOLATILITY 1 25% 9% Spread in cumulative total return between portfolio with "high ESG" bonds and "low ESG" bonds Cummulative excess return 8% 7% 6% 5% 4% 3% 2% 1% 2 15% 1 5% Eur IG credit spreads -1% itraxx Main (RHS) High vs Low ESG portfolios (LHS) Source: MSCI ESG, Bloomberg and Nordea Companies with high ESG scores generally have higher credit quality ESG a leading indicator of creditworthiness Our analysis indicates that companies with higher ESG scores tend to exhibit stronger and more stable operational performance. Furthermore, companies tend to demonstrate strengthening financial performance following an ESG rating upgrade, and vice versa. As a consequence, we argue that there is more to ESG than just avoiding costly event risk, and we find that the absolute ESG scores reduce portfolio risk, while ESG trends show merits as leading indicators of creditworthiness. In our analysis, companies with top ESG ratings have higher interest coverage, higher return on assets, higher FFO/net debt, less volatile revenues and lower net debt/ EBITDA. We believe this trend is here to stay owing to increasing ESG-related regulations, increased willingness to pay a premium for sustainable products and heightened interest in ESG among younger generations. AVERAGE CHANGE IN CREDIT RATIOS FROM 1 YEAR BEFORE TO 4 YEARS AFTER A CHANGE IN ESG RATING Net debt/ebitda Companies tend to demonstrate stronger financial performance following an upgrade in ESG rating, and vice versa ROA Interest coverage ra o FFO/net debt Upgraded companies Downgraded companies 3

4 Credit WORST ANNUAL RETURN PER ESG RATING 1 In the land of asymmetric returns, the smallest loser is king INTEREST COVERAGE RATIO PER ESG RATING AS OF x NET DEBT/EBITDA PER ESG RATING AS OF x 6x 2x 3x 1x 0x 0x Walking down the efficient frontier Risk-adjusted returns Across ESG scores but within the same credit rating, bonds from companies with higher ESG ratings generally have lower credit spreads, indicating that the elevated ESG risk is already priced into the bond. Naturally, this begs the question of riskadjusted returns. Do high ESG scores add to risk-adjusted returns, or is it just a walk down the efficient frontier? The "high ESG" portfolio has had a higher ex-post Sharpe ratio in nine out of the eleven years tested, indicating that it is more than just a risk-off play. We also find that the largest annual negative returns are larger and relatively more frequent in the low ESG bonds. This is particularly important owing to the return characteristics of bonds, with limited upside and far more downside. We believe that high absolute levels of ESG scores protect against downside, as they reduce the overall risk of a portfolio and capture factors not apparent in credit ratings. We also find changes in ESG scores to be correlated with forward credit ratios. Hence, buying bonds with high ESG scores reduces downside risk, while buying bonds with improving ESG ratings helps to capture upside in bonds. 4

5 Credit AVERAGE Z-SPREAD (BP) PER ESG RATING FOR COMPANIES WITH CREDIT RATING BBB AS OF

6 Disclaimer and legal disclosures Disclaimer Nordea Markets is the name of the Markets departments of Nordea Bank Abp and its branches Nordea Danmark, Filial af Nordea Bank Abp, Finland, Nordea Bank Abp, filial i Norge and Nordea Bank Abp, filial i Sverige. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgment of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. This publication or report may be based on or contain information, such as opinions, recommendations, estimates, price targets and valuations which emanate from: Nordea Markets analysts or representatives, publicly available information, information from other units of Nordea, or other named sources. To the extent this publication or report is based on or contain information emanating from other sources ( Other Sources ) than Nordea Markets ( External Information ), Nordea Markets has deemed the Other Sources to be reliable but neither Nordea, others associated or affiliated with Nordea nor any other person, do guarantee the accuracy, adequacy or completeness of the External Information. Although Nordea Markets information providers (Other Sources), including without limitation, MSCI ESG Inc. and its affiliates (the ESG Parties ), obtain information from sources they consider reliable, none of the ESG Parties warrants or guarantees the originality, accuracy and/or completeness of any data herein. None of the ESG Parties makes any express or implied warranties of any kind, and the ESG Parties hereby expressly disclaim all warranties of merchantability and fitness for a particular purpose, with respect to any data herein. None of the ESG Parties shall have any liability for any errors or omissions in connection with any data herein. Further, without limiting any of the foregoing, in no event shall any of the ESG Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets. Nordea Bank Abp, Satamaradankatu 5, FI NORDEA, Finland, domicile Helsinki, Business ID , VAT number FI Completion date: 22 October 2018, 11:37 CET Nordea Bank Abp Nordea Bank Abp, filial i Sverige Nordea Danmark, Filial af Nordea Bank Abp, Finland Nordea Bank Abp, filial i Norge Aleksis Kiven katu 7, Helsinki FI Nordea Finland Tel: Fax: Reg. no.: Satamaradankatu 5 Helsinki Smålandsgatan 17 SE Stockholm Sweden Tel: Fax: Grønjordsvej 10 DK-2300 Copenhagen S Denmark Tel: Fax: Essendropsgate 7 N-0107 Oslo Norway Tel: Fax: