Author Details

Hitendra D Varsani

Hitendra D Varsani
Executive Director, MSCI Research

Rohit Mendiratta

Rohit Mendiratta
Senior Associate, MSCI Research

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Corporate-bond performance by factors and ESG

Corporate-bond performance by factors and ESG

  • The MSCI USD Investment Grade (IG) Corporate Bond Index (“parent index”) experienced relentless bouts of market volatility over Q1 2020, despite these bonds’ relatively higher credit rating on the credit spectrum.
  • Within corporate-bond segments, defensive factors, e.g., low risk and quality, fared relatively well. Issuers with higher ESG exposure displayed more resilient excess returns. A similar trend existed over the last five years.
  • Relative to the parent index, energy underperformed while IT and healthcare outperformed in Q1 2020. Most MSCI USD IG ESG Leaders Corporate Bond Index sectors outperformed the respective parent index sectors.

COVID-19’s market impact has not only led to losses in equities (the MSCI ACWI Index returned -21.3% in Q1 2020) but also to extreme levels of volatility among investment-grade corporate bonds, as investors fled to cash. Major investment-grade fixed-income ETFs experienced price discounts of up to 6% to their reported net asset value (NAV), a level not seen since 2008. The 1-month (30-day) at-the-money (ATM) implied volatility of the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)1 peaked at 63.4% on March 19, 2020, before the Federal Reserve (the Fed) announced it would buy investment-grade corporate bonds, including ETFs linked to that market. By the end of the quarter, 1-month implied volatility fell to 26.4% but implied volatility remained elevated.

 

Implied volatility of ATM 1-month LQD ETF option

Implied volatility of ATM 1-month LQD ETF option

Source: OptionMetrics

The MSCI USD IG Corporate Bond Index returned -2.50% over Q1 2020, though that doesn’t tell the whole story. The exhibit below plots the duration-weighted option-adjusted spread (OAS) of the index on the left and the cumulative total returns and excess returns on the right. The index spread was at relatively tight levels of 107 basis points (bps) as of Dec. 31, 2019, but started widening on Feb. 19, 2020, as COVID-19 spread. To counter the anticipated economic slowdown, the Fed cut the benchmark interest rate by 50 bps on March 3. However, it was not until March 23 – when the Fed pledged to buy government bonds in unlimited amounts, and to purchase investment-grade corporate bonds and provide liquidity to the market – that the OAS started to ease from its peak of 338 bps, slipping to 246 bps at the end of the quarter.

 

MSCI USD IG Corporate Bond Index spread and performance during Q1

MSCI USD IG Corporate Bond Index spread and performance during Q1

Average spread and cumulative performance of the MSCI USD IG Corporate Bond Index over Q1 2020. The vertical line marks the pre-COVID-19 crisis market peak (Feb. 19) and the time before the Fed’s announcement of the U.S. economic stimulus package (March 20).

MSCI USD IG Corporate Bond Index
(Q1 2020 performance)
Total return Rate return Excess return
-2.50% 9.17% -11.68%

 

Factor and ESG indexes - Q1 performance

Throughout the first quarter of 2020, investors grappled with the financial implications that contagion risks could have on corporate balance sheets, cash flows, profitability and, even more critically, business continuity.

To understand how investors re-priced corporate bonds during this period, we plotted the performance of corporate bond factor-tilt indexes and ESG indexes. Defensive factors characterized by issuers with shorter durations and stronger balance sheets fared relatively better – perhaps due to investors’ confidence in their ability to withstand supply and demand disruptions during the widespread lockdown.

Among credit style factors, the low-risk factor2 outperformed by 0.42% based on total returns and 3.28% on excess returns, compared to the 1.69% and 1.77% outperformance of the quality factor. Carry (defined by bonds with relatively high OAS) experienced the largest drawdown, while the value factor, calculated as the residual spread not explained by other factors, was relatively muted. Issuers with higher MSCI ESG Ratings also outperformed the broad market. The MSCI USD IG ESG Leaders Corporate Bond Index, using best-in-class rating selection, outperformed its parent index, the MSCI USD IG Corporate Bond Index, by 0.75% and 1.29% in total and excess returns, respectively.

 

Performance of MSCI USD IG Corporate Bond factor-tilt and ESG indexes

Performance of MSCI USD IG Corporate Bond factor-tilt and ESG indexes

Active total returns and active excess returns across MSCI USD IG Corporate Bond factor tilt and ESG indexes in Q1 2020.

 

Corporate bonds with weak and/or deteriorating ESG ratings

To see how corporate-bond performance corresponded with ESG ratings, we plotted the total and excess returns of the MSCI USD IG Corporate Bond Index universe based on the underlying issuer’s MSCI ESG Rating. The highest ESG-rated issuers outperformed the weakest ESG rated issuers (the two categories are weighted by market value of the outstanding bonds).

 

Corporate-bond performance across MSCI ESG Ratings

Corporate-bond performance across MSCI ESG Ratings

Active total returns and active excess returns across MSCI ESG ratings in Q1 2020; analysis universe is the MSCI USD IG Corporate Bond Index.

While ESG ratings reflect the current assessment of an issuer, ESG ratings trends reflect how the ratings have changed over the last 12 months. In the exhibit below, we replicated the return analysis on issuers with a positive ESG trend (improvement in ESG ratings), neutral (unchanged ESG ratings) and a negative ESG trend (deterioration in ESG rating). We found that issuers with positive ESG trends outperformed those with negative ESG trends in Q1 2020, with most of the performance differential attributed to issuers with negative ESG trends.

 

Corporate-bond performance across MSCI ESG Rating Trends

Corporate-bond performance across MSCI ESG Rating Trends

Active total returns and active excess returns across MSCI industry relative ESG rating trend in Q1 2020; analysis universe is the MSCI USD IG Corporate Bond Index..

 

Performance of corporate bonds across sectors

To see how corporate bonds performed across sectors, we plotted the total and excess returns, relative to the universe, of the MSCI USD IG Corporate Bond Index universe based on the underlying issuer’s Global Industry Classification Standard (GICS®)3 sector. On March 8, 2020, the start of a price war between Saudi Arabia and Russia triggered a collapse in the price of U.S. oil (WTI Crude fell 67% during Q1 2020) and contributed to energy being the worst-performing sector in Q1 2020. Over the same period, the information technology and healthcare emerged as the best-performing sectors.

 

Performance across GICS sectors

Performance across GICS sectors

Active total returns and active excess returns across GICS sectors in Q1 2020.

 

ESG leaders’ overall performance

It is important to note that MSCI ESG Ratings are designed to be sector neutral, with an aim of preventing the universe from being dominated by issuers with higher ESG ratings in certain sectors (e.g., technology or healthcare), or that issuers with lower ESG ratings come predominantly from other sectors. This was particularly relevant in the context of the collapse in oil prices during this period that weighed on the energy sector.

In the exhibit below, we plot the relative performance of each GICS sector in the MSCI USD IG ESG Leaders Corporate Bond Index with respect to the corresponding sector in the parent index, the MSCI USD IG Corporate Bond Index, in Q1 2020. We focused our attention solely on ESG Leaders, given its higher active risk stemming from issuer selection, although a similar pattern was observed for ESG Universal. Among the 11 sectors, nine of the ESG Leaders sectors outperformed the parent index on an excess returns basis.

 

Relative performance of MSCI USD IG ESG Leaders Corporate Bond Index sectors 

 

Longer historical perspective

Defensive-factor and ESG indexes outperformed their parent indexes on an excess-returns basis over the 1-, 3- and 5-year period ended March 31, 2020, though results were less consistent when we examined total returns, largely due to duration biases (see table below).

Overall, dissecting corporate-bond performance over the first quarter of 2020 using factors and ESG ratings provided insight into fixed-income performance during stressed market conditions. This adds to our existing research examining ESG exposure and defensive characteristics such as systematic risk, idiosyncratic risk and profitability and our work on factors and corporate bonds.

 

Long-term performance of USD IG Corporate bond factor-tilt and ESG indexes

   
MSCI USD IG Corporate Bond index total returns
  Q1 2020 1 Year 3 Year 5 Year
Parent index USD IG Corp Bond -2.5% 6.0% 13.8% 18.1%
Factor indexes (tilt) Low Risk -2.1% 4.1% 10.4% 14.4%
Quality -0.8% 7.1% 14.7% 18.7%
Carry -5.3% 5.4% 14.4% 18.3%
Low Size -3.6% 4.6% 12.0% 15.7%
Value -3.0% 5.8% 13.4% 17.5%
ESG indexes ESG Leader -1.8% 6.5% 14.5% 18.4%
ESG Universal -2.0% 6.6% 14.2% 18.3%
MSCI USD IG Corporate Bond index excess returns
  Q1 2020 1 Year 3 Year 5 Year
Parent index USD IG Corp Bond -11.6% -8.6% -7.1% -4.6%
Factor indexes (tilt) Low Risk -8.4% -6.3% -4.6% -2.3%
Quality -9.9% -7.5% -6.0% -3.8%
Carry -16.6% -12.7% -11.0% -8.2%
Low Size -12.7% -10.1% -8.8% -6.8%
Value -12.1% -9.0% -7.5% -5.1%
ESG indexes ESG Leader -10.4% -7.7% -5.9% -3.7%
ESG Universal -11.2% -8.1% -6.8% -4.4%

All returns as of March 31, 2020.

 

 

1This is the longest-standing investment-grade bond ETF, with an inception date of July 22, 2002.

2Factor performance cited in this paragraph used various MSCI Corporate Bond Indexes as proxies. For the low-risk factor, we used the MSCI USD IG Low Risk Corporate Bond Index; for quality, the MSCI USD IG Quality Corporate Bond Index; for carry, the MSCI USD IG Carry Corporate Bond Index; and for value, the MSCI USD IG Value Corporate Bond Index.

3GICS, the global industry classification standard jointly developed by MSCI and Standard & Poor’s.

 

 

Further Reading

Bond ETFs and underlying price uncertainty

Foundations of ESG Investing

Factors and corporate bonds: Single- and multi-factor approaches to corporate credit

Regulation