By LARRY SWEDROE
The empirical research into the impact of environmental, social and governance (ESG) screening on corporate bond portfolios has found that not only do high ESG scores lead to lower corporate bond spreads, they also lead to lower exposure to the credit factor and reduced tail risk. This includes the 2020 study Primary Corporate Bond Markets and Social Responsibility and the 2021 studies Does a Company’s Environmental Performance Influence Its Price of Debt Capital? Evidence from the Bond Market and ESG Screening in the Fixed-Income Universe.)
Other research, such as the 2021 study Dynamic ESG Equilibrium, has found the same impact on equities — higher ESG scores lead to higher valuations. Thus, a corporation’s focus on sustainable investment principles leads to a lower cost of capital, providing them with a competitive advantage. It also provides them with the incentive to improve their ESG scores — sustainable investors are having an impact because cash flows affect valuations.
Rohit Mendiratta, Hitendra Varsani and Guido Giese contribute to the sustainable investing literature with their study How ESG Affected Corporate Credit Risk and Performance, published in the Winter 2021 issue of The Journal of Impact and ESG Investing, in which they examined the impact of incorporating ESG factors on the risk and performance of corporate bond portfolios. Their analysis was based on a corporate bond universe defined by the following indexes and included only issuers with MSCI’s ESG scores:
▪ MSCI USD Investment Grade (USD IG) Corporate Bond Index
▪ MSCI USD High Yield (USD HY) Corporate Bond Index
▪ MSCI EUR Investment Grade (EUR IG) Corporate Bond Index
▪ MSCI EUR High Yield (EUR HY) Corporate Bond Index
To analyse the relationship between ESG scores and financial variables, they first divided the analysis universe into terciles based on industry-adjusted ESG scores, with each tercile containing equal numbers of issuers and each issuer represented by its market-value-weighted corporate bonds. They chose to use industry-adjusted ESG scores over absolute ESG scores, as the industry-adjusted score provides a “best in class” approach, while the absolute score offers an aggregated view of a company’s total potential risks but may not differentiate as well between members of the same industry. Their data sample—chosen to obtain enough ESG coverage of the underlying index to draw meaningful conclusions—covered the period January 2014-June 2020. Following is a summary of their findings:
The differences in option-adjusted spread (OAS) durations between terciles were negligible across universes. Thus, they did not explicitly control for duration.
Across all universes, exposure to high historical average MSCI ESG Ratings coincided with a tighter OAS relative to low-ESG-rated securities — the lowest-ESG-rated companies had higher average credit spreads.
The overall ESG score generally resulted in more pronounced OAS-tercile differences across all issuer universes than did the individual pillar (E, S and G) scores — the total ESG score was the best identifier for differences of credit risk.
ESG was more relevant for differentiating risks in HY than in IG.
OAS spread compression per unit of ESG score spread was higher for longer-dated bonds for the EUR IG universe and was higher for shorter-dated bonds in both the USD HY and EUR HY universes. For the USD IG universe, the spread compression was not materially different between the longer- and shorter-dated bonds.
Companies with high ESG ratings showed a strong competitive advantage in terms of profit margins compared with lower-rated companies across all universes except USD HY.
Across all universes, high-ESG-rated companies showed higher levels of return on equity compared to low-rated companies.
High-ESG-rated companies had higher interest coverage ratio exposure, on average, on a sector-neutral basis than low-rated companies across all universes.
High-ESG-rated issuers had a higher exposure to quality (reflecting lower default risks) within their respective universes, especially when compared to lowest-ESG-rated issuers.
Issuers with high ESG ratings had less systematic volatility than those with low ESG ratings, and the impact was more pronounced in HY compared with IG.
High-ESG-rated issuers had lower levels of idiosyncratic risk compared to lower-ESG-rated issuers in the HY universe, while there were muted differences in IG.
The upper-ESG-rating tercile outperformed the lower tercile in each universe except for EUR HY. The outperformance was statistically significant for the composite and EUR IG universes, while for other universes it was statistically inconclusive.
The G pillar showed the weakest results after adjusting for all the common factors. This could be because governance-related risks were better understood by market participants and may therefore have been priced in by the market in contrast to social and environmental risks, which may be relatively less exposed by traditional credit analysis.
Mendiratta, Varsani and Giese also found that after adjusting for credit quality, the higher-ESG-rated issuers still had lower spreads compared to the lower-ESG-rated issuers. They concluded that ESG risks may not have been fully reflected in credit ratings. Another explanation is that the lower spread reflected investor preferences for bonds with higher sustainability scores.
Summarising, Mendiratta, Varsani and Giese concluded: “Good ESG characteristics were associated with financial properties such as better interest coverage ratio, better ROE, and better profit margins, all of which support better credit ratings.” They added: “We found that the higher-ESG-rated corporate bonds had lower systematic risk, lower spreads (within credit ratings), and therefore higher valuations.” They also concluded: “Companies with good ESG characteristics showed a lower likelihood of suffering from issuer-specific risks than companies with low ESG ratings, after accounting for common factors including credit ratings. Therefore, this provides evidence for ESG ratings to add a degree of information that can potentially help investors to manage or mitigate risks in their bond portfolios.”
Investor takeaways
The good performance of ESG bond portfolios, while delivering better risk exposures, can be interpreted as a result of the current high demand from investors for sustainable bonds — demand that has resulted in reductions in credit spreads (as shown by the authors of the 2021 study Dissecting Green Returns). Thus, despite the fact that issuers with higher ESG scores had lower yields, the recent increase in demand for sustainable bonds (leading to higher valuations) was more than sufficient to offset the lower yields. In addition, sustainable bond investors also benefited from risk reductions. Thus, they were able to express their values without sacrificing either nominal or risk-adjusted returns.
© The Evidence-Based Investor MMXXIV. All rights reserved. Unauthorised use and/ or duplication of this material without express and written permission is strictly prohibited.