ESG and Corporate Bond: A yield spread approach

By Svetlana Borovkova & Zhiyu Zhang / October 2022

Sustainability is currently a prominent theme in the investment management. Regulators and investors require asset managers to measure and report sustainability metrics such as ESG (Environmental, Social and Governance) scores for their portfolios. For stock portfolios, this process is well underway, as is an ongoing discussion on whether ESG selection negatively impacts stock portfolio returns. However, for fixed income portfolios, ESG measurement and portfolio selection has not been widely addressed yet. With this paper we aim to address sustainability issues in corporate bond investing. Using Refinitiv ESG scores, we investigate how these scores relate to corporate bond yields and bond portfolio performance.

Sustainable investing is currently firmly in the spotlight in the investment community. Regulators increasingly put pressure on asset managers to include sustainability in all steps of portfoliomanagement, and investors also starting to demand more sustainable choices in asset selection and allocation.

An ongoing discussion in equity investing is whether more sustainable choices of portfolios lead to different (i.e., lower) financial performance of such portfolios, and no consensus has been reached so far. Our work in this area, as well as those by other authors, suggest that more sustainable portfolios currently under-perform in US markets, but perform on par with benchmarks in Europe and Australia (see e.g., (Borovkova & Wu, 2020)). However, these issues have not been researched yet in the domain of fixed income investing. This is regrettable, since fixed income instruments – in particular, corporate bonds – form an important part of a well-diversified investment portfolio. Bearing lower risk than stocks, corporate bonds are liquid and they are able to generate higher returns than e.g., sovereign bonds.

In this paper, we investigate the interaction between Refinitiv ESG scores of firms and the performance of corporate bonds issued by these firms. We provide a rather straight-forward analysis of the relationship between ESG scores and corporate bond yields. More specifically, the following questions will be addressed in this report:

Is there any relationship between ESG scores (Environmental, Social, Governance pillars and overall ESG score) and corporate bond yields?
Can we observe similar ESG characteristics in bonds issued by companies from same sectors and similar credit ratings?
What impact of ESG scores have, as a sole ranking factor, on a corporate bond portfolio performance?

In the next sections we present the data, our methodology and discuss the results in detail. But first we summarize our main findings.

Using an extensive dataset comprising 6000 bonds of 657 US large cap companies, over the period 2010-2021, we observe a negative relationship between ESG scores and bond yields. This stems from the observation that a company with a higher ESG score is perceived to bear lower long-term risk, therefore it can raise capital at a lower cost. This negative relationship holds for the combined ESG score as well as for individual pillars E, S and G; however, this relationship is the strongest for the S (Social) pillar.

We observe that ESG rankings are evenly distributed among sectors, so by investing only in bonds of highly ESG-rated companies, one is able to preserve sector diversification in bond portfolios. The same holds for high yield vs investment grade bonds: there, the ESG scores are also distributed evenly, meaning that bond investors have the freedom to choose between high yield or investment grade bonds with similar sustainability criteria. Thus, by using ESG score ranking as a portfolio construction criterion, the resulted portfolio is still diversified with respect to sector and credit rating.

We investigate the performance of diversified bond portfolios of different ESG ratings, and show that the differences in portfolio yields range from 10 to 50 bp. This means that, although highly rated ESG companies generally yield less on their bonds, the actual sacrifice in yield of a bond portfolio is small. So there is no significant disadvantage in investing in corporate bonds while imposing even rather stringent sustainability criteria.

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