To analyse credit risks with greater precision, we developed a pricing model in 2017 to capture the influence of ESG factors on credit spreads. Today, we revisit our study to understand the impact that 2020 has had on that relationship.
Back in 2017 we analysed the link between 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 were able to demonstrate that companies with better environmental, social and governance (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 recently completed a third study, expanding the sample period to include the period from the start of 2012 to the end of a volatile 2020. We found that the significant relationship between ESG factors and CDS spreads persists: companies with better ESG practices tend to have lower CDS spreads, even after controlling for credit risks. Secondly, the explanatory power of the model increased from both the 2017 and 2018 studies. And finally, 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
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.
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, according to our credit analysts and engagement specialists, the desire by companies themselves to be ‘screened in' explains much of their acceptance of sustainability. We believe that senior management who embrace the consideration of nonfundamental factors appreciate that being a sustainability leader brings measurable operational, reputational, and cost‑of-capital benefits.
Once, twice, three times you've swayed me
Having completed this third review, we are encouraged that our pricing model for ESG factors not only remains robust, but its explanatory power 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 basis points, 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.
Manage transition risk, but buy transition opportunity
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. 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.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results.
For professional investors only. This is a marketing communication. The views and opinions contained herein are those of Mitch Reznick, CFA, Head of Research and Sustainable Fixed Income, Dr Michael Viehs, Head of ESG Integration, and Tarandeep Panesar, Senior Performance Analyst and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.
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 The QESG Scores, generated by our Global Equities at the international business of Federated Hermes, rank each stock worldwide in accordance with its ESG risk.