Companies with stronger environmental, social and governance (ESG) practices benefit from tighter CDS (credit default swaps) spreads than those with poorer ESG procedures, according to new data from the Credit and Responsibility teams at Hermes Investment Management.
Pricing ESG risk in credit markets: reinforcing our conviction, follows on from a 2017 study1 conducted by the teams to develop a pricing model to capture the influence of ESG factors on credit spreads. This showed a convincing relationship between ESG characteristics and credit spreads manifesting as an ESG risk curve. This year, the teams expanded the research to include an additional 500 data points.
The research found that:
- Companies with higher QESG Scores2, i.e. the strongest ESG credentials, have tighter credit spreads than those with lower QESG Scores.
- Even after controlling for credit ratings, there is still a significant correlation between CDS spreads and the ESG performance of companies.
- The model generated by the research’s insights helps identify mispriced issuers based on their ESG characteristics. Investors should be wary about issuers with very low credit spreads and a very poor ESG performance.
Mitch Reznick, CFA, Co-Head of Credit, Hermes Investment Management, said: “While the industry has spent years of intellectual capital on pricing operating and financial risks – the core credit risks – we were frustrated that there was no equivalent for ESG. As a result we decided to develop in-house research to examine the relationship between ESG factors and credit spreads. The ESG credit curve that we ended up with is an early, pioneering attempt to price ESG risks.”
Dr. Michael Viehs, Associate Director - ESG Integration, Hermes Investment Management, said: “This research reinforces the necessity of integrating ESG factors into investment decision making in fixed income. Our analysis shows that credit ratings are still not fully capturing the ESG risk dimension of an issuer and therefore it helps us identify issuers whose deteriorating ESG practices could lead to underperformance. By replicating and extending our previous research, we found a stronger relationship between CDS spreads and QESG Scores which matches our qualitative assessments.” (See Chart 1).
Chart 1 illustrates companies with the weakest QESG Scores, forming quintile one, have the widest spreads and those with the highest QESG Scores, forming quintile five, have the tightest spreads. This relationship remains consistent with our original study and also with the three sub-scores: for environmental risk (QE), social risk (QS) and governance risk (QG). Compared to our first study, the gap between the first and fifth quintiles has widened further, indicating a more compelling correlation between CDS spreads and QESG Scores.
Chart 1. Average annual CDS spreads by QESG quintile: the gap between the best and worst performing ESG performers has widened over time
Source: Own calculations using data sourced from Hermes Global Equities and Bloomberg as at June 2018. Corrected for outliers.
Source: Own calculations using data sourced from Hermes Global Equities and Bloomberg, as at February 2017. Corrected for outliers.
- 1 Pricing ESG risk in credit markets, April 2017, Hermes Investment Management. https://www.hermes-investment.com/uki/blog/perspective/pricing-esg-risk-in-credit-markets/
- 2 The QESG Score, generated by Hermes Global Equities, is a measure used across Hermes’ investment teams which is derived from a range of sustainability data, including proprietary insights from the stewardship and engagement team, Hermes EOS
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