New research shows that screening for “green” environmental, social and governance (ESG) criteria has led to positive risk-adjusted returns for corporate bonds. High demand among investors for those bonds contributed to the outperformance, raising the question of whether it will be sustained.
The empirical research into the impact of ESG screening on corporate bond portfolios (including the 2020 study, “Primary Corporate Bond Markets and Social Responsibility,“ and the 2021 study, “Does a Company’s Environmental Performance Influence Its Price of Debt Capital? Evidence from the Bond Market”) has found that high ESG scores (signifying a positive profile on ESG issues) have led to lower corporate bond spreads. The research (such as the 2021 study, “Dynamic ESG Equilibrium”) has found the same impact on equities – higher ESG scores led to higher valuations. Thus, a corporation’s focus on sustainable investment principles has led to a lower cost of capital, providing them with a competitive advantage. It also provided them with the incentive to improve their ESG scores.
That’s good news for investors, as it demonstrates that through their focus on sustainable investment principles, they have caused companies to change behavior in a positive manner. In addition, the lower cost of capital provides incentive for firms to “go green” in terms of new products and services. Increased investor demand has led to a dramatic increase in the issuance of “green” bonds, with a total issuance of $706 billion in 2020 and a total of $1.7 trillion outstanding (though still a small fraction of the overall bond market, representing approximately $100 trillion).
Fabio Alessandrini, David Balula and Eric Jondeau contribute to the literature with their November 2021 study, “ESG Screening in the Fixed-Income Universe,” in which they examined the impact of a screening process based on ESG scores for an otherwise passive portfolio of investment-grade corporate bonds. They used as a benchmark the Bloomberg Barclays Global Aggregate Corporate Index, a large, conventional bond market index covering investment-grade securities worldwide. Their data sample covered the period 2014-2020. They analyzed the USD and EUR segments separately to prevent the characteristics of these portfolios from being affected by currency volatility. The screening scheme involved, for a given ESG score, excluding from the portfolio bonds issued by firms with the lowest scores, representing 10%, 25% and 50% of the market value. Following is a summary of their findings:
- For each of the ESG pillars, European firms had higher average scores, whereas firms in emerging countries usually had lower scores. The fact that the scores of European firms were higher than the scores of North American firms can be explained by the more stringent regulations applied in Europe on sustainability issues.
- Screening has been often associated with a substantial improvement in the risk profile without negatively impacting returns.
- ESG-tilted portfolios led to large negative exposure (i.e., protection) to credit risk (ESG portfolios typically overweighted high-quality securities), and reductions in downside risk and liquidity risk.
- The reduction in the exposure to both downside and credit risks was greatest for the environmental criterion.
- Screening based on the E score was where most of the reduction in risk took place, making this criterion particularly relevant in moving the portfolio toward a more defensive composition.
- ESG exclusion has a substantial effect on portfolio exposures (industries and countries).
- Screening at the regional and sectoral levels allowed investors to eliminate undesirable regional and sectoral exposures while delivering similar ESG scores and risk-adjusted performances.
Summary
Their findings led Alessandrini, Balula and Jondeau to conclude: “An overall ESG screening strategy results in a substantial increase in the targeted score with no deterioration of risk-adjusted returns.” They did add that the good performance of ESG portfolios relative to the benchmark, while delivering better risk exposures, can be interpreted as a result of the currently 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 benefited from risk reductions. Thus, they were able to express their values without sacrificing either nominal or risk-adjusted returns.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that screening for “green” environmental, social and governance (ESG) criteria has led to positive risk-adjusted returns for corporate bonds. High demand among investors for those bonds contributed to the outperformance, raising the question of whether it will be sustained.
