ESG High-Yield Bonds Have Not Outperformed
ESG proponents claim that “green” high-yield bond returns offer better risk-adjusted returns. New research disproves this claim, although environmental, social and governance (ESG) investors do not incur a penalty by owning green bonds.
On June 17, 2020, in response to growing demand for fixed-income benchmarks that consider ESG criteria, ICE Data Indices introduced several series of corporate and government bond indexes. All three US high yield (HY) ESG indexes exclude bonds of companies with Sustainalytics scores of 20 or more for “controversial weapons – most significant involvement,” and one of the three also excludes bonds of companies with scores of 30 or more for overall ESG risk. In introducing the ESG indexes, ICE Data Indices retroactively provided daily descriptive statistics, including returns, from December 31, 2016, forward.
The three US high-yield ESG indexes are subsets of the ICE BofA US High Yield Index:
ICE US High Yield ESG Tilt Index (Bloomberg ticker: H0SG)
Excludes bonds of companies with significant involvement in controversial weapons and tilts the weights of remaining issues in favor of those with better (lower) ESG risk scores.
ICE US High Yield Duration-Matched ESG Tilt Index (Bloomberg ticker: H0SD)
Follows the methodology of the ESG Tilt Index but further adjusts the issue weights to match as closely as possible the ICE BofA US High Yield Index’s interest rate exposure across rating categories and industry sectors.
ICE US High Yield Best-in-Class ESG Index (Bloomberg ticker: H0OS)
Excludes bonds of companies with significant involvement in controversial weapons and bonds of companies with high ESG risk. It adjusts the weights of the remaining issues to closely match the ICE BofA US High Yield Index’s rating and industry sector distributions.
Martin Fridson, Lu Jiang, Zhiyuan Mei and Daniel Navaei contribute to the sustainable investing literature with their study, “ESG Impact on High-Yield Returns,” published in the Spring 2021 issue of The Journal of Fixed Income. They began by examining the ESG indexes’ composition for confounding factors (also known as “lurking variables”), such as differences in weighted average credit ratings and maturity/duration that might affect their analysis.
In late 2015 Moody’s and S&P announced that they would take ESG dimensions more explicitly into consideration when determining credit ratings. Thus, all else equal, companies with lower (i.e., better) ESG risk scores will have higher credit ratings. Following is a summary of their findings:
- The new indexes disproportionately exclude bonds with composite ratings lower than BB – issuers of B and CCC or lower bonds are more involved than their higher-rated counterparts in activities and practices that run afoul of the ESG arbiters. The more selective an index is (moving down from ESG tilt to best-in-class), the higher its issue-based concentration in the top rating tier.
- Like the rating agencies, the market rates the ESG portfolios more favorably than the standard all-HY index – option-adjusted spreads (OAS) are lower.
SOURCE: ICE Indices, LLC. Data as of June 30, 2020
- ESG-based high-yield indexes produced greater historical returns, lower volatility and thus a greater Sharpe ratio than a standard high-yield index. However, the differences were not statistically significant. The BB Index similarly outperformed the All High Yield Index, and the ratings of the three ESG indexes were higher than for the All High Yield Index but lower than the ratings of the BB Index.
SOURCE: ICE Indices, LLC. Data as of June 30, 2020
- The apparently superior downside protection provided by ESG-oriented funds in down markets is explained by two major confounding factors: ESG-based high-yield indexes are underweighted in energy bonds and lowest-rated issues. Thus, the ESG indexes’ superior downside protection derives largely from compositional features that are merely side effects of selecting issues on the basis of favorable ESG scores.
- The three ESG indexes achieved their total return edge over the ICE BofA US High Yield Index – statistically insignificant though it was – in the months in which the ICE BofA US High Yield Index posted negative price returns.
- There was no evidence that high-yield investors can obtain superior downside protection by concentrating in bonds of companies that lack significant involvement in controversial weapons – bonds of issuers that had significant involvement in controversial weapons had higher returns than those that did not.
- Energy companies with good ESG scores showed no tendency to provide superior downside protection in a high-yield bear market.
Their findings led the authors to conclude: “In the case of high-yield bonds, our findings do not support the contention of some ESG proponents that concentrating in issues with favorable ESG scores improves investment performance.” On the other hand, ESG investors did not pay a penalty in the form of lower risk-adjusted returns for expressing their values in their investments.
There is another confounding factor related to the increasing demand for sustainable investment strategies that the authors did not address.
Investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to higher valuations and short-term capital gains for their bonds (and stocks) – realized returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in “green asset” returns even though “brown” assets earn higher expected returns. In other words, there is an ambiguous relationship between sustainability risk and returns in the short term. Without this understanding, investors can misinterpret findings that appear to show a lack of a sustainability premium. Given the continued trend in sustainable investing, it will be a while before we reach a new equilibrium. In the meantime, despite investors requiring a risk premium for sustainability risks, green securities (both stocks and bonds) can outperform brown ones.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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