The CFA survey revealed that ESG integration is more of a mainstream practice in equities compared to fixed income – in the US and other parts of the world.

Equity prices relative to corporate bond spreads tend to be more reactive to ESG issues, as discussed earlier. However, there also appears to be more empirical studies on the public equities versus fixed income side that validates the efficacy of ESG integration. This could be because a fixed income study would be challenged by the ability to make clean comparisons in the bonds of companies with different ESG profiles, due to disparities in their maturity dates, optionality features, interest rate duration risk and levels of subordination.

In July 2015, Calvert Research and Management published the results of a back test study that evaluated the impact of ESG factors (based on Reuters’ scoring system) on fixed income investment performance over a 10-year period (2003-2013) through a series of simulations. The study used credit default swap (CDS) spreads as a proxy for corporate bond returns, given the instrument’s bullet maturity structure and isolation of credit risk, allowing for applesto-apples comparisons. Below is a summary of the main takeaways from the study and their implications.

ESG factors demonstrate meaningul efficacy in fixed income investing 

Companies ranked in the top half compared to bottom half endtiles by aggregate ESG scores experienced 6.8% and 4.8% in outperformance on a leverage-neutral and sectorneutral basis respectively, as measured by the annual rate of change in CDS spreads. These results appear to statistically validate the value proposition of investing in the credit of companies with superior ESG profiles.

Individual sustainability pillars offer varying degrees of alpha-generating advantage in fixed income investing

Companies ranked in the top half compared to bottom half endtiles by individual environmental, social and governance scores experienced 5.4%, 4.1% and 0.6% in outperformance on a leverage-neutral basis, as measured by the annual rate of change in CDS spreads. A simulation conducted on a sector-neutral basis showed meaningful outperformance only on the environmental factor. This simulation suggests that while governance issues, such as a company’s capital allocation strategy (equitable treatment of equity and debt stakeholders), are more commonly linked to equity and fixed income performance and therefore more frequently considered in investment analysis compared to environmental or social factors, the latter two sustainability pillars have the potential to offer greater alpha opportunity.

ESG factors demonstrate varying degrees of efficacy across the credit quality spectrum

In another simulation, in which the companies were grouped into quartiles based on their leverage ratios (as a proxy for fundamental risk and credit quality), a compelling observation was that, within the lowest leveraged group, those companies ranked in the top half by aggregate ESG score had no alpha-generating advantage over their bottom half-ranked counterparts. On the other hand, within the second lowest, second highest and highest leveraged groups, those companies ranked in the top half compared to the bottom half endtiles lexperienced 14.1%, 7.8% and 15.2% in outperformance respectively. The simulation done on a sector-neutral basis yielded very similar results. This simulation suggests that lower quality as opposed to higher quality investment-grade companies (as represented by the lowest and second lowest leveraged quartiles respectively) are, from a spread performance perspective, more likely to benefit from the consideration of ESG factors. Arguably, companies with the highest credit quality profiles usually have the largest market capitalizations and are best positioned to make significant investments in financial and human capital towards ESG-related implementation. Hence, ESG information for the highest quality companies is disseminated with greatest transparency and efficiency to the marketplace, minimizing their alpha-generating potential compared to lower quality companies, where ESG disclosure is more sporadic and creates an information advantage for ESG-minded investors.

ESG factors demonstrate an important role in fixed income investing, despite challenges 

It is understandable why the adoption rate of ESG integration and the level of confidence in its value proposition has been weaker on the fixed income relative to equities side. Shortcomings exist in the measures that are used as proxies for corporate bond returns. Arguments include credit ratings lagging the market in reacting to fundamental events and average credit spreads not capturing comparable maturities across all corporate bonds7. CDS spreads are arguably a good proxy for bond spreads, as CDS contracts are able to overcome the mismatch problem with bonds and the two markets are tightly coupled under normal market conditions. However, the liquidity of the CDS market has weakened significantly in the last decade as a result of the collapse of the synthetic CDO market which was responsible for driving the high volume of secondary trading in CDS pre-crisis, as well as tighter regulation that has rendered trading in derivative instruments more expensive. Weaker liquidity and higher transaction costs in the CDS market can cause distortions in CDS spreads, and therefore it is important to revisit the most informationally efficient instrument and reliable proxy for corporate bond returns in the future, as market conditions change.

Despite these caveats, the Calvert Research and Management study demonstrated the efficacy of ESG in fixed income investing, and also revealed the importance of breaking down such an analysis further. A closer look at contributions to returns from individual sustainability pillars and leverage ratio quartiles reveals that alpha-generating opportunities vary in magnitude across different crosssections of the credit universe.

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Paper on financial performance of ESG integration in US investing