Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Hermes’ Mitch Reznick, co-head of credit, and Dr Michael Viehs summarise their report entitled “Pricing ESG Risk in Credit Markets”.
Over the last few years much intellectual capital has been thrown at understanding, analysing and measuring environmental, social and governance risks when investing. Even though we know that credit risk is the primary driver of credit spreads, we also know unequivocally that ESG factors impact valuations, too. Therefore, as fiduciaries, we are compelled to assess and price ESG risks, just as we do for credit risks.
The problem for us was that while there is a plethora of ways to price credit risk, we lacked models to price ESG risks. And since assessing ESG risk has been integrated into our investment process for years, after working with the Responsibility, Global Equities and Hermes EOS teams, we decided we now had the ability to create an ESG pricing model.
The key to doing so was that we have a proprietary quantitative measure of ESG risks that we can map against credit spreads. This allowed us to build a relative-value scatter chart that looks very similar to what you see when pricing pure credit risks. We believe this to be an innovative – if not pioneering – way to further integrate ESG considerations into our investment process.
Finally, in addition to introducing more precision to our overall desire to assess and price all risks, be they credit, fixed-income, market, liquidity, or ESG, the results of the study have given us a tool to identify companies that could pose a risk to performance and those names that could be opportunities.
To capture ESG risks we used the quantitative ESG scores that our Global Equities generates. In order to price the ESG risks of securities, they must be linked with valuations. This is not as straightforward for credit instruments as it is for more standardised securities like equities because, put simply, bond mathematics get in the way.
Coupon, term structure, call structure and rates – they all impact credit spreads, making it difficult to isolate the contribution of ESG risk. But these influences are muted when we analyse CDS instead of cash bonds. By considering CDS spreads as proxies for priced-in risks, the data are essentially cleansed of issue-level and exogenous events, providing the most homogenous expression of credit risk across a suite of names on a global basis.
What Did We find?
Our unconditional analyses revealed that, on average, those issuers with the lowest ESG scores always exhibit the highest CDS spreads, whereas companies with higher ESG scores generally have lower CDS spreads. Our analyses allowed us to document that this correlation holds true for the three sub-categories, environmental, social, and governance quality as well. Poor ESG scores go hand in hand with high CDS spreads.
However, one could argue that credit ratings, as a pure measure for credit risk, should also pick up ESG scores and corresponding ESG risks. Our paper sheds light on this argument and we documented that there are several companies that have reasonable credit ratings while simultaneously exhibiting relatively low ESG scores.
Hence, we conclude that these companies might be exposed to additional risks stemming from ESG factors because of their poor ESG performance, which might not be factored into common credit ratings.
To give this argument more weight, we undertook an attempt to develop a pricing model for CDS spreads. To do so, we conducted a simple regression analysis which linked the level of CDS spreads with ESG scores and credit ratings. The reason behind this approach was to find out what the additional contribution of ESG risk is on CDS spreads, above and beyond the risks picked up by credit ratings. The econometric results of this exercise are compelling. Not surprisingly, we found that credit ratings have the biggest impact on CDS spreads. However, at the same time, we also found a significant negative correlation of ESG scores with CDS spreads.
We conclude that while credit risk is still the most important driver of CDS spreads, good ESG practices also have a risk reduction effect on companies.
Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com
