- Institutional investors are increasingly integrating ESG considerations in corporate-bond portfolios and seeking to understand the impact of ESG factors on portfolio-level fundamentals and risk characteristics.
- Hypothetical portfolios constructed with higher-ESG-rated issuers had stronger cash flows, lower systematic risk and fewer idiosyncratic risks than portfolios composed of lower-ESG-rated issuers.
- The reduction in idiosyncratic risk, which measures risks beyond traditional credit-related factors, offers support that ESG integration provided incremental insight into risk and performance during our study period.
While environmental, social and governance (ESG) investing makes up an increasingly large footprint in equity portfolios, ESG integration into fixed-income portfolios has not yet taken off on a comparable scale. Institutional investors may wish to consider incorporating ESG risk considerations in bond portfolios, given the potential loss of capital in adverse scenarios and more limited upside potential in the asset class.
In our previous blog post, we found that ESG ratings had characteristics distinct from credit ratings. In this blog post, we dig deeper, highlighting the characteristics of hypothetical high-ESG-rated corporate-bond portfolios in terms of exposure to issuer fundamentals such as profit margins, profitability and interest coverage, as well as volatility and tail risk.
Financial Characteristics of High- and Low-ESG-Rated Corporate-Bond Portfolios
We expanded our previous study on ESG fundamentals in equity portfolios and investigated how ESG impacted the risk and performance of corporate bonds through three potential transmission channels:
- Cash flows — assessing how ESG characteristics are associated with financial variables that typically directly enter credit-risk analysis and might therefore complement credit ratings
- Systematic risk — projecting an ex-ante systematic-risk estimate derived from a portfolio risk model and assessing credit valuations
- Idiosyncratic risks — assessing the risk of severe incidents and downside tail events after accounting for credit ratings
We assessed the plausibility of these transmission channels in terms of improved fundamentals and risk characteristics by examining how ESG-score-ranked issuer terciles1 were linked to financial variables that are part of the proposed economic transmission, as summarized in the exhibit below. For each transmission channel, we chose financial variables that are commonly used in financial literature and may support each transmission channel’s economic argument.
ESG Tercile Analysis to Validate Transmission Channels
The empirical analysis uses a corporate-bond universe defined by the MSCI Corporate Bond Indexes that covers both investment-grade (IG) and high-yield (HY) credit segments denominated in U.S. dollars and euros. Overall, our analysis consists of three universes: composite, IG and HY.2 The study period for the analysis is January 2014 to June 2020. All analysis was conducted at the issuer level and based on month-end data sampling.
Channel 1: Cash-Flow Exposures of High- and Low-ESG Bond Portfolios
We begin our analysis with the cash-flow channel, where we expected high-ESG-rated issuers to be more competitive, more profitable and better at debt servicing, ultimately leading to better overall credit quality (as measured by credit ratings) than that of low-ESG-rated issuers within the same sectors.
The exhibit below shows the cash-flow channel.
Cash-Flow Channel Shows High-ESG Issuers Had Stronger Financial Characteristics
Mean of month-end equal-weighted average sector-neutral exposures to company net margins, return on equity (ROE), interest-coverage ratio (interest expenses covered by cash flow from operations) and credit quality (as defined by its average credit rating), for the highest- (T3) and lowest-ESG-score (T1) terciles, over the period from January 2014 to June 2020.
We found that, across the three universes considered, high-ESG-rated issuers indeed had, on average, higher net profit margin, return on equity and interest-coverage ratio than low-ESG-rated issuers. Overall, we found that high levels of ESG characteristics were associated with better financial properties and credit ratings relative to their sector peer groups.
Channel 2: Systematic Risk of High-ESG Corporate-Bond Portfolios
Next, we assessed the systematic-risk channel. We expected high-ESG-rated issuers to be less vulnerable to systematic market shocks and hence associated with a lower cost of capital and higher valuations, as compared to low-ESG-rated issuers.
The exhibit below shows the systematic-risk channel. To gauge the systematic-risk and factor exposures, we relied on an excess-return3 risk model’s estimation using a cross-sectional regression for factor returns that accounted for both traditional (e.g., duration-times-spread (DTS) sector exposure) and credit-based style factors (e.g., quality, value, size, carry, risk and liquidity). A risk-model setup allows us to gain both a holistic and granular view of risk characteristics, as opposed to relying on a single metric (e.g., beta). The detailed methodology can be found in our paper Foundations of ESG Investing in Corporate Bonds: How ESG Affected Corporate Credit Risk and Performance.
Higher ESG Rating, Lower Average Systematic Risk
Mean of month-end equal-weighted average annualized systematic risk, option-adjusted spread (OAS), carry exposure (defined as log OAS standardized within the same credit-rating peer universe) and value exposure (defined as OLS residual obtained when regressing OAS on size, credit rating and duration), for the highest- (T3) and lowest-ESG-score (T1) terciles, over the period from January 2014 to June 2020.
We found that, across each of the three universes, high-ESG-rated issuers had significantly lower systematic risk, lower spreads — both absolute (option-adjusted spread) and within credit-rating buckets (carry) — and marginally lower value-factor exposure, i.e., higher valuations compared to low-ESG-rated issuers.
Channel 3: Idiosyncratic Risk of ESG Corporate-Bond Portfolios
Finally, we assessed the idiosyncratic-risk channel. We expected high-ESG-rated issuers to better manage their business and operational risks beyond what is explained by their credit ratings. We estimated idiosyncratic risk from the same risk model as used in the systematic-risk channel. The exhibit below illustrates the idiosyncratic-risk channel.
Higher-ESG-Rated Issuers Showed Lower Idiosyncratic Risk
Mean of month-end equal-weighted average residual return value at risk (VaR, calculated as the 10th percentile of forward 12-month residual returns), likelihood of a tail event (calculated as the fraction of issuers in the lowest decile of forward 12-month residual returns) and annualized idiosyncratic risk, for the highest- (T3) and lowest-ESG-score (T1) terciles, over the period from January 2014 to June 2020.
We found that, across each of the three universes considered, high-ESG-rated issuers had lower idiosyncratic risk and lower absolute value-at-risk (VaR) measures during our study period. Issuers were able to successfully mitigate severe incidents, and there was a lower percentage of issuers below the lowest residual-return decile, as compared to low-ESG-rated issuers during our study period. These results are arguably more critical for bondholders, given their asymmetric exposure to potential gain or loss of capital.
Three Ways ESG Exposure May Shape the Characteristics of Corporate-Bond Portfolios
In short, each of the transmission channels improved our understanding of how ESG characteristics provided added insights into our hypothetical portfolios:
- The first transmission channel, the underlying cash-flow assessment, demonstrated how higher-ESG-rated portfolios were associated with stronger cash-flow metrics and might therefore complement credit ratings.
- The second transmission channel — systematic risks, derived from a portfolio risk model — showed that higher-ESG-rated portfolios displayed lower risk than lower-ESG-rated portfolios, as well as commanded a marginal valuation premium.
- The third transmission channel, idiosyncratic risk, measured risks beyond traditional credit-related factors and showed higher-ESG-rated portfolios were less exposed to severe incidents and experienced less downside risk during our study period.
All told, these findings suggest that ESG characteristics provided insights for credit risk beyond traditional credit-rating assessments.
1We first divided the analysis universe into terciles based on industry-adjusted ESG scores, with each tercile containing an equal number of issuers and each issuer represented by its market-value-weighted corporate bonds. The upper tercile (T3) reflects issuers with relatively high MSCI ESG Ratings, while the lower tercile (T1) reflects the lowest ratings.
2The three study universes are defined as IG, represented by the MSCI USD Investment Grade Corporate Bond Index and MSCI EUR Investment Grade Corporate Bond Index; HY, represented by the MSCI USD High Yield Corporate Bond Index and MSCI EUR High Yield Corporate Bond Index; and composite, a combination of the four aforementioned individual universes where issuers are equally weighted again. The analysis excluded issuers not rated by MSCI ESG Research.
3The bond’s total return in excess of duration-matched Treasury/bund returns.