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Hermes research reinforces the strong relationship between ESG factors and credit spreads

Home / Press Centre / Hermes research reinforces the strong relationship between ESG factors and credit spreads

Mitch Reznick, CFA, Co-Head of Credit and Head of Credit Research

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

QESG 1

Source: Own calculations using data sourced from Hermes Global Equities and Bloomberg as at June 2018. Corrected for outliers.

QESG 2

Source: Own calculations using data sourced from Hermes Global Equities and Bloomberg, as at February 2017. Corrected for outliers.

  1. 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. 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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Mitch Reznick, CFA Co-Head of Credit and Head of Credit Research Mitch joined Hermes in February 2010 as head of research on the Hermes Credit team. Prior to this he was co-head of credit research for the global credit and hybrids team at Fortis Investments. Other roles at Fortis included portfolio manager of European high yield funds, based in London, and senior credit analyst, based in Paris. Before this he worked as an associate analyst in the leveraged finance group at Moody’s Investors Service in New York. Mitch earned a master’s degree in International Affairs at Columbia University in New York City and a Bachelor’s degree in History at Pitzer College, one of the Claremont Colleges in California. He is a CFA charterholder; a member of the Capital Markets Advisory Committee of the IFRS Foundation, the Association for Financial Markets in Europe High Yield Investor Committee, and the Credit Advisory Committee for the PRI; and a workstream member of the UK-China Green Finance Task Force.
Read all articles by Mitch Reznick, CFA
Michael Viehs Dr Michael Viehs is responsible for intelligent proxy voting in Germany, corporate engagements on environmental, social, and governance issues and for conducting research on sustainability and responsible investing with a focus on consumer goods and retail, mining, oil and gas, pharmaceuticals and utilities. Before his appointment at Hermes EOS, Michael was research director at the Smith School of Enterprise and the Environment at the University of Oxford and visiting assistant professor at the School of Business and Economics at Maastricht University in the Netherlands. Michael is a visiting research associate at the University of Oxford and a research affiliate with the European Centre for Corporate Engagement. He presented his research at several top academic and industry conferences in Germany, the Netherlands, Sweden, Spain, the UK, the US and South Africa. Michael holds a BSc in International Business Economics, an MSc in International Business and a PhD in Finance from Maastricht University.
Read all articles by Michael Viehs

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