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The Hunt for Alpha in ESG Bond Funds

High ESG scores lead to both higher equity valuations and lower bond spreads.

Along with the increased interest by investors in sustainable investment strategies, there has been an explosion in academic research on the impact of implementing environmental, social and governance (ESG) constraints on the risk and returns of equity portfolios. Yet, while capital allocation to ESG fixed income funds keeps growing, research on ESG fixed income investing is receiving less attention.

Inna Zorina and Lux Corlett-Roy contribute to the sustainable investing literature with their study “The Hunt for Alpha in ESG Fixed Income: Fund Evidence from Around the World,” published in the fall 2022 issue of The Journal of Impact and ESG Investing, in which they examined whether ESG fixed income funds generate out- or under-performance after controlling for systematic fixed-income factors.

Their data set, from Morningstar, comprised index and active fixed-income mutual funds and exchange traded funds (ETFs) with a European, U.S. and global investment focus that explicitly indicated any kind of sustainability, impact or ESG strategy in their prospectus or offering documents over the period 2011 to 2020. They began by noting: “Incorporating ESG signals/applying ESG screens can contribute to control of credit risk, mitigate tail risk, lower bond yields/increase bond prices or adversely affect portfolio returns and the level of diversification due to the imposed ESG constraints.” Following is a summary of their findings:

While ESG fixed income funds with a higher level of risk generally produced higher returns, most ESG fixed income funds did not produce statistically significant positive or negative gross alphas. Only 7% of funds managed to deliver greater returns at a lower level of risk relative to the respective benchmark, with a decrease in the share of funds with positive, statistically significant alphas over time. Across ESG fixed income funds with a European, U.S. and global focus, performance was mainly driven by systematic fixed income factor exposures (term and default risk).

While funds with higher expense ratios may offer investors more targeted ESG exposure, expense ratios remained a significant drag on fund performance in the ESG fixed income space—consistent with prior research, there was an inverse relationship between expense ratios and fund performance.

These results led Zorina and Corlett-Roy to conclude: “ESG fixed-income mutual funds and ETFs have not consistently delivered statistically significant gross alpha controlling for key fixed-income factors. The majority of alphas are statistically insignificant and therefore indistinguishable from zero. This conclusion is similar across fixed-income funds with a European, US, and Global ESG investment focus.” Such findings are consistent with those of Mohamed Ben Slimane, Eric Brard, Théo Le Guenedal, Thierry Roncalli and Takaya Sekine, authors of the 2019 study “ESG Investing and Fixed Income: It’s Time to Cross the Rubicon,” and those of Michael Halling, Jin Yu and Josef Zechner, authors of the 2020 study “Primary Corporate Bond Markets and Social Responsibility.” Both found that there was a robust negative relation between ESG scores and issue spreads in the corporate bond primary market even when controlling for bond ratings and various firm characteristics such as net book leverage, size, industry and profitability. Good ESG performance was rewarded in primary bond markets by lower credit spreads, with the effect strongest for low-rated bonds; for highly rated issuers (i.e., AAA or AA), the spread difference based on aggregate E and S scores was insignificant.

Halling, Yu and Zechner also found some evidence that the explanatory power for spreads has decreased in recent years. They hypothesized that a potential explanation for such a pattern is that in late 2015 Moody’s and S&P announced they would take ESG dimensions more explicitly into consideration when determining credit ratings, thereby reducing the information content in the respective E and S scores. Fitch, the third leading rating agency, joined Moody’s and S&P in taking ESG dimensions into account in 2017. Halling, Yu and Zechner added that their “results suggest that ratings do not fully subsume all the effects of ESG scores on credit spreads.” They concluded: “Our evidence suggests that some ES-dimensions capture information that is relevant for default risk.”


Investor Takeaways

The empirical evidence demonstrates that high ESG scores lead to both higher equity valuations and lower bond spreads (reflecting reduced risks). Thus, we can conclude that a focus on sustainable investment principles leads to lower costs of capital, providing companies with a competitive advantage and thus the incentive to improve their ESG scores. In addition, the ESG research, including the 2020 study “Corporate Sustainability and Stock Returns: Evidence from Employee Satisfaction,” has found that improving ESG scores also improves employee satisfaction. And that too can improve corporate profitability.

Larry Swedroe is the head of financial and economic research at Buckingham Wealth Partners.

This information is provided for general information purposes only and should not be construed as financial, tax or legal advice.

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