Analysis of corporate bonds reveals better risk-adjusted returns for issuers with higher ESG ratings
The value of considering ESG factors in equity investments is well-established, particularly when it comes to mitigating risks. The natural next question is whether ESG integration also helps in fixed-income investing – and with respect to corporate bonds, that may very well be true.
In a recent blog post, Rohit Mendiratta, Hitendra Varsani, and Guido Giese of MSCI Research described how they analyzed the MSCI Investment Grade (IG) and High Yield (HY) Corporate Bond Indexes by dividing them into ESG terciles based on industry-adjusted ESG scores. Each tercile contained an equal number of issuers – the segment with highest-rated issuers was designated T3, and the lowest-rated issuers fell under T1 – with each issuer’s corporate bonds given representative weights based on their market value.
“[O]ver 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,” the researchers said, citing their findings based on data from January 2014 to June 2020.
They also noted that during downturn periods observed in 2016 and 2020, T3 issuers had significantly lower drawdowns – the maximum drawdown for T3 was 10.57%, almost half the 21.25% for T1 – supporting the assertion that an ESG strategy possesses inherent defensive characteristics.
“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,” they said. “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.”
They said the data from January 2014 to July 2020 showed three distinct performance regimes. From 2014 to 2018, performance differences between the corporate-bond terciles were muted; between 2018 and 2020, issuers with high ESG ratings outperformed those with low ratings, which the researchers said could reflect the recent wave of ESG adoption among investors. T3 issuers’ performance accelerated even further during the period from January 2020 to July 2020, indicative of ESG’s relative success during the COVID-19 pandemic.
To determine whether any particular pillar of ESG held outsized explanatory power, the three looked at the performance and risk of individual sector-relative E-, S-, and G-pillar scores for their analysis universe. They found that among the three pillars, social factors showed the strongest difference in terms of residual returns reflected by the gap between T3 and T1, while environmental factors displayed the highest degree of 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,” they said.
