- We explored the impact of incorporating environmental, social and governance-related (ESG) factors on the risk and performance of corporate-bond portfolios.
- We found ESG ratings had characteristics distinct from credit ratings and delivered additional insights into risk and performance.
- The aggregate MSCI ESG Rating score showed stronger results in terms of reducing risk than the individual E-, S- and G-pillar scores.
A growing number of institutional investors are looking to incorporate ESG factors into the fixed-income investment process, alongside traditional financial factors. But does incorporation of ESG considerations when constructing corporate-bond portfolios give investors information beyond what they might learn from credit ratings? Our analysis shows that ESG ratings and credit ratings address different aspects of credit-risk exposures and should not be confused or seen as interchangeable. In this blog post, we assess the performance of ESG — and its individual E, S and G pillars — both before and after accounting for credit factors such as credit ratings. We found that higher-ESG-rated portfolios realized higher risk-adjusted returns, and the aggregate MSCI ESG Rating score showed stronger results in terms of reducing risk than the average individual pillars. A more comprehensive study can be found in our research paper.
Constructing High- and Low-ESG Portfolios
Our analysis universe was based on the MSCI Investment Grade (IG) and High Yield (HY) Corporate Bond Indexes for USD and EUR. We 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.2
To disentangle the impact of spread duration and ESG, one may consider creating duration-neutral terciles. But we found the differences in spread duration among the terciles were minimal; for that reason, creating duration-neutral terciles would have added complexity for little benefit.
How the ESG Terciles Broke Down by Statistics
|ESG Terciles||Number of Issuers||ESG Score||OAS (bps)||Effective Duration||Spread Duration||MSCI Average Credit Rating|
Mean of equal-weighted-average monthly samples over January 2014 to June 2020. Sample universe restricted to issuers with available ESG scores. The MSCI Average Credit Rating is the average rating of S&P and Moody’s with the lower credit-rating number representing higher credit quality.
Performance and Risk of ESG Portfolios
We compared the excess performance of the highest- and lowest-ESG-rated terciles over a one-month holding period.3 Total returns are calculated using MSCI’s methodology for fixed-income indexes before adjusting for any transaction-related costs. The exhibit below shows that over the sample period, the high-ESG-rated issuers (T3) experienced better risk-adjusted returns due to higher excess returns and lower excess risk at the same time. We observed that the high-ESG-rated issuers also had significantly lower drawdowns during the downturn periods, indicating the inherent defensive characteristics of an ESG strategy.
Issuers from High-ESG-Score Tercile Had More Resilient Excess Returns
|Excess return (%)||Excess risk (%)||Risk adj. excess return||Max drawdown (%)||Portfolio Beta|
Average equal-weighted excess performance for low- and high-ESG-score terciles from January 2014 to July 2020. Return and risk numbers are annualized. Beta is calculated with respect to an equal-weighted (by issuer) universe. Sample universe restricted to issuers with available ESG scores.
Is the ESG Performance Simply Due to Credit Rating?
We recognized that the excess returns may include returns related to issuers’ credit ratings — and perhaps other factor exposures inherent in ESG portfolios. To address this, we examined the residual return performance for T1 (low ESG ratings) and T3 (high ESG ratings). The residual returns are obtained from a cross-sectional regression of excess returns on a set of credit factors, including credit ratings.4 The exhibit below shows the cumulative active residual returns of the high- and low-ESG-score terciles along with the residual return spread between the two (T3 - T1) for our analysis universe
High-ESG-Score Tercile Outperformed After Adjusting for Credit Ratings
Cumulative equal-weighted active residual return of high- (T3) and low-ESG-score (T1) terciles with respect to the analysis universe, along with the high-vs.-low ESG spread (T3-T1), from January 2014 to July 2020. Sample universe is restricted to issuers with available ESG scores.
Even after adjusting returns for credit-rating exposures, we found that the high-ESG-rated issuers outperformed the low-ESG-rated issuers over the analysis period. We note three distinct regimes. First, the period from 2014 to 2018 was characterized by muted performance differences. Second, during 2018-2020, high-ESG-rated issuers outperformed low-ESG-rated issuers and the entire universe, possibly explained by the recent rise of ESG adoption by investors. Finally, from January 2020 to July 2020, there was an acceleration in high-ESG-rated issuers’ performance during the onset of the COVID-19 pandemic.
Thus, we concluded that ESG ratings provided additional information relevant to the identification of risk that was not fully captured by credit factors including credit ratings.
The ESG Whole Was Greater than the Sum of Its Parts
The exhibit below assesses the performance and risk of individual sector-relative E-, S- and G-pillar scores for our analysis universe, before and after accounting for credit factors. It is quite interesting to note that, among the three pillars, the S-pillar score showed the strongest difference in terms of residual returns (T3-T1), while the E pillar showed the highest risk reduction, in both excess and residual returns. We also observed that the total MSCI ESG Rating score showed stronger results in reducing both excess and residual risk than the three individual pillar scores — which means the aggregation of E, S and G risks into a combined ESG score added financial value.
Performance of Individual E, S and G Pillars Compared to Total ESG …
… Before Accounting for Credit Factors
… and After Accounting for Credit Factors
Average equal-weighted excess return, excess risk, residual return and residual risk spread between the high- (T3) and low-rated (T1) E-, S- and G-pillar-score terciles and industry-adjusted ESG score terciles, over the period from January 2014 to July 2020.
The Value of ESG Ratings
In our analysis, we found that ESG ratings had characteristics distinct from credit ratings and delivered financial value after accounting for credit ratings. In short, the two types of rating systems complemented each other.
We also observed that the aggregate MSCI ESG Rating score reduced risk more than the individual E-, S- and G-pillar scores.
1As indicated by the list of investor signatories to the UN-supported Principles for Responsible Investment.
2While creating the ESG terciles at the level of the analysis universe, one might expect some credit-rating bias due to differences in ESG scores of IG vs. HY bonds. In our research, we show results for each of the individual universes as well. When conditioning on single-currency IG or HY universes, the correlation between ESG ratings and credit ratings was notably weaker.
3Excess performance means subtracting the average currency- and duration-matched U.S. Treasury/German Bund returns of the tercile.
4The credit factors spanned the traditional factors like duration-times-spread (DTS) sector exposure, as well as the credit style factors — namely, quality, value, size, carry, risk and liquidity. For more details, see: Mendiratta, R., Varsani, H., and Giese, G. 2020. “Foundations of ESG Investing in Corporate Bonds: How ESG Affected Corporate Credit Risk and Performance.”