Pricing ESG risk in credit markets

Back in 2017, we analysed the link between environmental, social and governance (ESG) factors, and credit spreads in an effort to refine our ability as fixed income investors to more accurately price factors beyond traditional operating and financial risks. We presented the results of that analysis in which we demonstrated that companies with better ESG practices tended to have lower credit default swap (CDS) spreads, even after controlling for credit ratings and other risk factors. Using the results, we plotted predictions of CDS spreads for given values of ESG scores, drawing an innovative implied ESG pricing curve.

In 2018, we published an updated study with a longer sample period which produced similar results. We have now conducted our third iteration, expanding the sample period to include the period from the start of 2012 to the end of a volatile 2020.  We launched the process of updating the original study in 2020, however with COVID-19 impacting fundamentals and sentiment and triggering violent moves in credit spreads, we decided to wait and use the full ESG-CDS dataset for whole calendar year 2020. This would allow us to test the resilience of our model and the relationship between ESG and credit risk through the volatility as a measure of its veracity and strength. 

We have now proved that the significant relationship between ESG factors and CDS spreads persists and the explanatory power of the model increased from both the 2017 and 2018 studies. High levels of market volatility throughout 2020 did not significantly affect this relationship (a closer investigation of the relationship within 2020 is, however, warranted).

THE RELATIONSHIP RECONFIRMED 

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Our latest research shows that even when controlling for operating and financial risks (measured by credit ratings), as ESG factors deteriorate, credit spreads widen. Because the reverse is also true, this relationship has very important investment implications. Chart 1 shows the implied ESG pricing curve using the full dataset from 2012 to 2020.

Our results suggest that credit markets are likely to reward companies that make the transition from ESG laggards to leaders with tighter CDS spreads. This observation is particularly poignant given that asset owners and fund managers are increasingly looking to ‘screen in’ companies seen as ESG and sustainability leaders to reinforce the ESG credentials of their portfolios. In this environment, companies with credible transition stories represent an excellent investment opportunity as they join the elite sustainable leaders of their industries. 

Moreover, the desire by companies themselves to be ‘screened in’ explains much of their acceptance of sustainability. We believe senior management who embrace the consideration of non-fundamental factors appreciate that being a sustainability leader brings measurable operational, reputational, and cost-of-capital benefits.

GIVING CREDIT TO ESG 

There is no shortage of evidence of the benefits of investing in sustainability leaders. Companies with better ESG practices tend to have a lower cost of capital, lower operational costs and are less vulnerable to negative cash events than their less sustainable peer. It has also been shown that successful company engagement by institutional investors on ESG considerations can have positive implications for a company’s performance. 

Conversely, companies with poor ESG characteristics tend to have a higher cost of capital because they are exposed to more risks and costs stemming from non-financial externalities – such as fines for not complying with environmental or health and safety regulations – that undermine corporate financial performance. 

ESG RISK AND CREDIT SPREADS 

With financial markets having undergone significant changes since our original study in 2017, we wanted to test whether the conclusions of our previous research held true. As demand for more sustainable investment products increases, does the market continue to reward ESG leaders as expressed through relatively tighter CDS spreads? And how is this dynamic affected by periods of high volatility? 

The results are comparable to those in our original paper (Chart 2): companies with the lowest QESG scores have the widest spreads, while companies with the highest QESG scores have the tightest spreads. A QESG score ranks each stock worldwide in accordance with its ESG risk. Also, as with our previous studies, the widest dispersion of spreads is in the first decile, which is occupied by the band of lowest QESG scores. We believe this band is more likely to include stressed or distressed companies who either do not have the capacity to focus on ESG factors and/or whose weakened ESG factors have transitioned into operating and financial risks. These factors eclipse the influence of ESG factors, being so elevated that the vitality of the companies at the wide end of the range is in doubt. 

As you can see, the boxplots in Chart 2 show that for the full sample period 2012-2020 the median CDS spread for deciles four to 10 are very similar, with a median range between 64 and 77 basis points (bps) – this is again in line with the original study. Noteworthy is the fact that the median CDS spreads for deciles two and three are lower than in the original study and much more similar to the median values of the other deciles. This implies that median CDS spreads for these deciles came down in 2019 and 2020. 

To make these observed trends more visible, we repeated the exercise but calculated the boxplots across ESG quintiles so that there were more observations in each group. Companies with the worst ESG credentials, on average, in quintile one, have the highest CDS spreads along with the widest variation in observed CDS spreads.

CONCLUSION

Having completed this third review, we are encouraged that our pricing model for ESG factors not only remains robust but it’s explanatory power, as measured by the R-squared, has actually increased. What’s more, the model has performed effectively through one of the most volatile periods ever in credit markets. This makes us confident that when we use the model in credit committees it is providing that additional precision that we seek. 

Looking at the trajectory of the implied ESG pricing curve, we can see that in the higher quality QESG categories there is little differentiation in credit spreads (this will be the subject of future analysis). However, at 75 bps, the difference between high quality and low quality is stark. In multiple terms, the weakest bucket is nearly twice as wide in spread as the strongest bucket. This tells us that the market recognises ESG quality – and dramatically so. 

The investment implications of the market’s ability to differentiate between low ESG quality and high ESG quality creates real opportunities. While it is important to control for operating and financial risks, we believe buying into credible transition stories can deliver alpha – whilst also benefiting society – as the market recognises an improving ESG story. Our own investors have increased their scrutiny of sustainability credentials, whether mainstream or thematic (e.g. UN Sustainable Development Goals; climate change). Given the rising interest in ESG throughout the investment industry and the surge in sustainability-themed funds and strategies, we see rising demand for the so-called ESG leaders. 

Demand for sustainability-themed bonds in the primary market is often stronger than for mainstream bonds, suggesting investors are pining for ESG leaders to strengthen the underlying sustainability credentials of their portfolios. With this in mind, we believe buying credible transition stories will deliver alpha as they evolve into leaders and become ‘screened-in’. Our ESG pricing model shows that our investors will be rewarded for identifying these transition opportunities. 

Mitch Reznick is head of sustainable fixed income, and Michael Viehs is head of ESG integration at the international business of Federated Hermes.